As concerns about mortgage defaults mounted last summer, investors grabbed super-safe Treasuries and avoided bonds that posed more risks. Besides getting rid of shaky, high-yield securities, the sellers also dumped municipals--bonds that traditionally have low default rates. Hurt by the sales, national long municipal funds only returned 1.3 percent in 2007. During the same period, national long government funds, which hold many Treasuries, returned 9.8 percent.
The weak showing left municipals at bargain levels. To appreciate just how cheap tax-free bonds are, consider that in late January 2008, 10-year AAA municipals yielded 3.68 percent. That is the equivalent of a taxable bond yielding 5.11 percent for an investor in the 28 percent tax bracket. At the same time, 10-year Treasuries only yielded 3.63 percent. Municipals rarely enjoy such a wide after-tax advantage over Treasuries. The last time municipals reached such levels was in 1999, when investors were selling boring tax-free bonds to buy technology stocks. The following year, municipal funds revived, producing double-digit returns. Will municipals enjoy a comparable recovery in this cycle? Probably. Default rates remain tiny, and investors will likely come back to municipals in search of fat, tax-free yields.
Which long municipal fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that are at least three years old and have a minimum of $75 million in assets. Three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.
The screens reduced the field from 213 contenders to 71. Top finishers included Wells Fargo Advantage Municipal and Alliance Bernstein Municipal Income. But we awarded the title to Eaton Vance National Municipals, which had the highest five-year returns among the finalists as well as a high Alpha when we ran the numbers late last year.
Eaton Vance gained the title by following a contrarian approach, buying bonds that others shunned. After purchasing a bond, portfolio manager Tom Metzold is willing to hold for three to five years, waiting for unloved securities to rebound. If a bond appreciates, Metzold typically sells his position quickly. "When bonds rise dramatically, we sell and look for other bargains," he says.
Metzold bought some of his biggest winners in 2001 and 2002, when the economy was shaky and investors shunned bonds rated below investment grade. At the time, Eaton Vance purchased securities that were used to finance Indian casinos. The bonds paid fat yields of 10 percent because investors feared that the new casinos could default or refuse to pay their debts. But Metzold reasoned that the cash flow from the businesses would be more than adequate to cover interest payments on the bonds. His thinking proved correct, and the prices of the bonds climbed.
Other successful holdings were airline bonds issued by American and Continental. Following the terrorist attacks of 2001, air traffic slowed, and many airlines appeared on the brink of bankruptcy. But some bonds were backed by planes or valuable space in terminals, which seemed likely to hold their value. As traffic improved, the value of the bonds climbed.
Today Metzold is not interested in most Indian casinos or airline bonds because prices of both have risen. Instead, he is finding value among investment-grade bonds in unusual corners of the markets, including insured municipals. Insured issues have run into trouble because of the problems faced by the insurance carriers. Besides providing backing for municipal bonds, many insurers also cover troubled mortgage securities. Investors fear that the credit ratings of insurers will fall as mortgages default, a process that could hurt the value of insured municipal bonds. The fears have become exaggerated, says Metzold. He says that in normal times some AA-rated municipal bonds are backed by insurance, which enables the issues to qualify for ratings of AAA. But now some investors figure that the insurance is worthless, and they are pricing the bonds as if they have ratings below AA. "It doesn't make sense that the insured bonds are trading below comparable bonds that are uninsured," says Metzold. "Even if the insurers run into trouble, it is extremely unlikely that the bonds will default."
Other unusual bonds that Metzold likes are backed by Goldman Sachs. The big investment bank does not usually issue municipal bonds, but after 2001, businesses in lower Manhattan were given the right to use tax-free bonds. The aid was to provide support for companies that were struggling to recover from the after-effects of the terrorist attacks. While Goldman, a famously profitable company, hardly needed government assistance, the investment bank qualified for the program, and it began issuing tax-free bonds. "The bonds are extremely safe because they have the backing of Goldman," says Metzold.
Besides looking for undiscovered bonds, Eaton Vance also aims to pick up small gains by taking advantage of temporary shifts in bond markets. Bonds are issued by thousands of states and cities around the country, says Metzold. And because issuers do not coordinate the flow of deals, there are times when the market is flooded with new bonds. This causes prices to fall a bit. "By buying at the right times, we can pick up 10 or 15 basis points on a trade," says Metzold. "When we make a lot of small scores, we wind up winning the game."
Stan Luxenberg (firstname.lastname@example.org) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.