Reported pricing probe latest 'oh no' moment for muni bond biz

Financial advisers are worried that the recent news that the Securities and Exchange Commission is investigating how municipal bond funds price risk in their portfolios may cause investors to rush for the exits — just when things were settling down. Today, The Wall Street Journal reported that the SEC is investigating whether municipal bond fund managers are overstating the value of the riskiest bonds in their portfolios, thus misleading investors. Kevin Callahan, a spokesman at the SEC, declined to confirm or deny the probe. The news broke just as outflows from municipal bond funds have started to wane. Net outflows from municipal bond funds were $973.86 million in the one-week period through Feb. 16, which was the first time in 10 weeks that the category saw less than $1 billion in outflows, according to Lipper FMI. “The first thing I thought when I saw that headline was, ‘Oh no, not another one,'” said Alan Dalewitz, a senior vice president at Herbert J. Sims & Co. Inc. The municipal bond market has been hit with a string of negative headlines about the possibility of municipalities' defaulting. In December, Meredith Whitney, a bank analyst who predicted the credit market crash, forecast 50 to 100 “significant” muni bond defaults this year. Advisers worry that the latest probe may cause investors who were just starting to calm down to run for the hills, advisers said. “If you are municipal bond fund investor, and first you saw Meredith Whitney on ‘60 Minutes' and then this, you may feel like everything is stacked against you and sell,” said Jason Thomas, chief investment officer at Aspiriant LLC, a multifamily office with $7.5 billion in assets. Pricing problems in the municipal bond market, particularly for thinly traded bonds, aren't anything new. The problem is inherent in the system, experts said. “It's more of an art than a science to price an illiquid bond,” said Eric Jacobson, director of fixed-income research Morningstar Inc. Fund managers often rely on third-party pricing services to determine the value of bonds. Often the way these agencies price bonds is by looking at how comparable bonds are trading. If a bond doesn't have many comparables, however, this can be difficult to do. In some cases, mutual fund managers may disagree and increase the price that the third-party stated for a bond, experts said. “Traders and portfolio managers have been left to fend for themselves in terms of establishing the value of bonds in some instances,” said Matt Fabian, managing director of Municipal Market Advisors. And given the rampant outflows from muni bond funds, there may be more pressure today on mutual fund managers to manipulate the pricing of their bonds, said Robert Kane, founder of BondView LLC, which operates a website for municipal bond investors. “The municipal bond market is illiquid and the funds that hold those bonds are subject to that same illiquidity,” Mr. Kane said. “It's a petri dish for potential illegal mispricing activity, because these funds don't want to show enormous losses.”