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No-Frills Income

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For some portfolio managers, it’s all about the thrill of the hunt for an elusive, singular beast. They narrow down the universe of possible investments and when they find their quarry, they examine every inch of its being. They want to be the first and maybe the only manager to corner their find, and hope to harvest the fruits of their labor for themselves and their investors. Of course, that’s a description that mostly applies to higher-growth, smaller-cap investments. But in the aftermath of a bear market, a war, and a bond bubble, and during an election year marked by more terror and financial market volatility, there are plenty of investors who are eager to invest in something a little more stable.

Founded in 1983, the Franklin Federal Tax-Free Income Fund [FKTIX] is an investment worth a look for such investors. Sheila Amoroso, portfolio manager of the fund, boasts that her company’s “deep team has been well entrenched in the muni market for a very long time.” There are no frills to her investment strategy, no heavily calculated formulas to live by. There’s just one simple rule in her fund: pay out high income and provide good returns to investors. “Income focus is definitely what clients should be seeking if they want to purchase our fund,” she says. With the bulk of their bond holdings rated AA and AAA, Amoroso, who’s managed the fund since 1987, and her team of two co-managers–Francisco Rivera, who joined the team in 1996, and Carrie Higgins, who joined this year–and a host of analysts also look at A- and BBB-rated bonds.

According to Standard & Poor’s, for the 10-year period ended February 27, 2004, Franklin Federal Tax Free Income Fund/A had an average annualized total return of 5.8%, versus a total return of 5.4% for all Long-Term Municipal (National) funds. This fund received four stars from S&P and Morningstar.

Though this specific fund’s performance is noteworthy, its parent company–Franklin Templeton–has been the subject of an SEC investigation into late trading and market timing (see “Taking Steps” sidebar on page 66.)

We recently spoke with Amoroso in her San Mateo, California, office about her fund’s performance and how some of the larger economic issues don’t affect municipal bond funds.

This is a team-managed fund. How are the management responsibilities broken up among the three of you? Is there a lead manager? I am manager of the whole department and co-manager of the entire municipal bond department here at Franklin. We have 39 funds and $54 billion in assets under management. Obviously, I am doing other things aside from portfolio management, and when you are dealing with the municipal market, there are many sub-markets–different states and how they trade, whether bonds are trading at more retail levels versus institutional levels, and different sectors. So there are two co-managers who follow the more intimate details of the markets and do a lot of the day-to-day decision-making, whereas I take a broader approach, and get involved with the big decisions and big deals.

Tell me about your screening process. What requirements do you have for your municipal bonds? We have a disciplined investment strategy that is employed across all our funds. Our primary objective by prospectus for all of our muni funds is to pay out high tax-free income. When looking in the muni market and deciding whether to buy or sell a security, our initial guiding principal by prospectus is that we can only buy investment-grade securities. We look at what is going on in the market, what is available in the market, and then compare that to how our portfolio is structured and whether placing a trade, investing cash, or doing a swap makes sense. On the surface that sounds easy. However, when you are dealing with all of these different sub-markets, then understanding a $7.5 billion portfolio is a big effort. That is the basic premise for all of our funds and not just the tax-free fund.

The bulk of the credits in the market are very high quality at AA- and AAA-rated. We do look at A-rated and BBB-rated credits, but that is where our research group comes in. They are the ones that look at new issues, and then monitor any of the securities in the portfolio that are credit driven, like the As or the BBBs. We work with them as a team in order to make decisions on new purchases or credits that they feel are deteriorating and on credits that are coming to the new-issue market. They look at them and decide whether it makes sense to add that to the portfolio. Then the portfolio managers come in and look at the credit relative to other credits they own and whether the yield will pay for the risk.

Yields have decreased so much on all kinds of fixed income, from Treasuries to corporates. How do you keep your fund’s return in positive territory in this environment without adding too much risk? In a couple of ways. Our focus is on income. While yields have declined, we do hold older, higher-coupon securities that pay more than where we can invest today. We hold onto those. We don’t want to sell a 5.5% or 6% coupon and reinvest today at 4.25% or 4.5%. This is a well-seasoned fund, so we have bonds that were purchased five, ten, or fifteen years ago that are still in the portfolio. Our ability to pay out income obviously is stretched when yields are declining because we have bond calls and new cash flow that we are reinvesting in the current interest rate environment, but we still do hold our older, higher-coupon securities that allow us to pay out above-average income.

According to S&P, this fund invests primarily in long-term bonds. Is there one type of bond that you tend to invest in more often than others? Because this is a long-term income fund, we tend to look out 15 to 30 years, and the bulk of our purchases over the past several years have been in AA and AAA bonds. However, because the portfolio does hold older securities, the average maturity of [bonds in] the fund is 19 years.

Has the 2003 tax bill and the lower capital gains tax on dividends affected the muni-bond world at all? There was a lot written about that and as we were getting closer to that bill becoming a reality, the idea was it would severely impact the municipal market because it would be competition for after-tax income. However, we didn’t think that was going to be the case because when you compare stocks and bonds, that’s like comparing apples and oranges, especially municipal bonds. When a municipality issues a bond, its obligation is to pay principal and interest when due. And so you buy, say, a 5% coupon out 15 years; you expect to get that coupon payment of 5% every month. That is not going to change. And munis have a very strong history of paying off their debt, whereas with stocks you have the added volatility and higher risk, and dividends that are not set in stone. They are not obligated to pay [dividends] and they can change [their mind] at any time. We really didn’t think that tax bill was going to have a major impact, and it turned out that it didn’t.

The amount of cash in the portfolio is less than 1%–is it always so low? Yes. Our focus is to pay out income, so we don’t want to keep a lot of cash in the portfolio earning 1%. Right now the yield curve is pretty steep, so if we can buy a bond at 4.5% you are getting paid to do that. Since we began managing munis, we have had a strategy of being fully invested in the portfolio. We are not here trying to make interest rate predictions and then deciding whether we should build up cash or spend cash. What we do every day is look at the relative value in the market. Then we make a decision whether we should spend cash or sell some securities that we own and buy some securities available in the market, because we are going to improve the portfolio in some way. That strategy is a disciplined approach that we have applied for the last 25 years in all of our funds. I think that looking at our total return and income return over the last 25 years, it has proven to be a pretty good strategy.

Is there an index or a peer group that you would compare this fund with? We compare ourselves to our Lipper peer groups.

There was a big bubble in bonds at the end of 2002 and part of 2003 as many investors exited equities because of the bear market. Since the bulls resumed, investors have moved assets out of bonds and back into equities. What has been your fund’s experience? Has this “hot money” affected your assets under management? What you tend to see, if you look at some of the Investment Company Institute information on cash flows into municipal bond mutual funds, is that there is movement based on interest rates. [There is a stronger] cash flow into bonds and bond funds when rates decline. When rates are rising, you see negative cash flows. However, we still have a very large, stable base of investors who do not try to time the market, and are looking for that consistent monthly income, which is what we are all about. There has been a lot of information out in the past two and a half years about how rates can only go up from here. And that kind of spooks people, I think. After what happened with the stock market, we obviously don’t want to go through another situation like that. However, in the muni markets, the bottoms don’t go to zero. State and local governments don’t go out of business.

Where do you see this fund fitting into someone’s portfolio? Munis in general are for someone who has made the decision that they want to own bonds after looking at their tax situation. This fund, because it is a national fund and it is available to people across the country, can be for people in states that don’t levy income taxes or states that have very low income taxes. Or for people who own munis and maybe want to diversify out of the current state that they are in, maybe they want to own both state and national funds. When you are looking at munis, it is really a question of the math and what you are earning on an after-tax basis versus other opportunities in the bond market like Treasuries, corporate bonds, or high-yield bonds.

That is one obvious benefit of working with advisors. They understand the ins and outs of different tax situations and after-tax total returns that people need to think about when they are looking into the bond market. Sometimes people look at a nominal distribution rate on the fund and don’t think about comparing it with a taxable fund.

Why should someone put money into your fund as opposed to a similar fund? We have a strong history of being in the top quartile of income returns, and take a very disciplined approach to doing that. We don’t leverage the portfolio and we don’t use derivatives. It is a plain-vanilla approach that hopefully means no surprises to our investors. There are other fund groups out there that do it a little differently. Based on what an advisor’s client wants out of a portfolio and what their risk tolerance is, this might be the perfect place.

What are your thoughts on the yield curve in general–where do you think it might be going? The yield curve is steep and the Fed [controls] short-rates, while long rates are generally driven by global factors and inflation. I don’t think either one of those is going to change in the near term. At some point the Fed will start to raise short rates. I can’t tell you when that is going to happen because that has been predicted to happen every year for the last few years. And I don’t spend time trying to predict that. We are looking to buy the relative value of the market at the time and build a diversified portfolio. Based on the fact that you have a pretty steep yield curve right now, I think we will see some type of flattening at some point, but when [that will happen] is the big question.

What is your outlook for the overall market and economy, particularly in light of the 2004 presidential election? The economy is slowly improving but it isn’t meeting expectations on job growth, and I think that is one of the contributing factors to low inflation, though that is not the only issue. Right now on the goods side, we have deflation, and on the services side, inflation. We are slowly moving forward, but I don’t think you would call it robust.

How will the election affect the muni market? Generally, not much. You are dealing with very stable state and local governments here. They don’t change quickly and they pay their debt on time, so regardless of who is president, I don’t see a huge shift in what people’s perception of our market will be.

Megan L. Fowler writes about business issues from Fairbanks, Alaska. She can be reached at [email protected].