Certain Muni Portfolios Find a Happy Medium
Most investors in municipal bond mutual funds probably don’t consider themselves reckless, but many are probably assuming more risk than they realize.
It’s not that the vast majority of bonds issued by cities, states and county governments are likely to go belly up--far from it. But most tax-free funds hold long-term bonds, which are the type most vulnerable to a drop in value should interest rates climb.
In fact, muni bond funds as a group have longer average maturities than all other major categories of fixed-income portfolios, according to Morningstar Inc. of Chicago.
A fund’s average maturity is the average number of years in which its individual holdings are expected to come due. It doesn’t mean the fund itself will liquidate within that span--most managers merely reinvest the proceeds from maturity bonds into new ones--but it does provide some insight on volatility.
During periods of flat or declining interest rates, longer-term bonds are the place to be, since they generally pay higher yields and offer greater appreciation potential. But they’re also more exposed to interest rate risk and could get banged up plenty if rates rise.
Enter intermediate-term muni portfolios, which hold bonds coming due in five to 10 years or so.
These funds, which are comparatively rare but becoming more common, take the middle road between risk and return. They opt for higher yields than the abysmally low rates being paid by short-term portfolios, while assuming less risk than do long-term funds.
And at the moment, for various reasons, intermediate munis look even more attractive than usual, some experts say.
For example, the intermediate-term portfolio of the Benham National Tax-Free Trust recently was paying an SEC 30-day yield of 4.22%. That’s about 85% of the 4.93% rate paid by the trust’s long-term portfolio.
Yet the intermediate fund is only 62% as volatile, says G. David MacEwen, a municipal bond manager for Benham, headquartered in Mountain View, Calif. “Right now, you can pick up a lot of the yield (available on long-term funds) without picking up the extra volatility,” he said.
In general, intermediate-term munis are capturing about 75% of the yield paid by longer-term bonds while subjecting investors to just half the risk, according to William H. Reeves, a senior vice president and muni fund manager for Putnam Investments of Boston.
On a yield basis, intermediate munis also look good in relation to intermediate-term treasuries, to which they’re often compared. Said William T. Reynolds, managing director and head of the muni division at T. Rowe Price Associates in Baltimore: “The intermediate end of the muni bond yield curve is very attractive in absolute, relative and risk-adjusted terms.”
Another advantage of intermediate muni funds is reduced call risk, the danger that a higher-yielding bond will be called or forcibly redeemed by the issuer prior to maturity. By calling bonds, a city, county, state or other municipality essentially can refinance its debt--replacing older, more expensive bonds with new, lower-yielding ones. Bondholders lose an attractive security and must reinvest the proceeds at current lower rates.
Compared to intermediate portfolios, longer-term muni funds tend to hold a larger percentage of bonds facing possible calls, MacEwen says.
Few fund managers are predicting sharply higher interest rates anytime soon.
The economy is still too sluggish--and inflation too low--for that to happen. Inflation is projected to average just 3.2% for all of this year and 3.3% in 1994, according to a recent survey of economists by Blue Chip Economic Indicators, a newsletter based in Sedona, Ariz. The consensus is that interest rates also will stay at modest levels.
Even if rates did jump, some experts believe that muni funds wouldn’t be hit as hard as one might expect, because of the nature of the tax-free market. Specifically, demand for municipal bond funds has been heavy for several years and could intensify if President Clinton pushes through proposals to raise taxes.
Yet muni prices haven’t gone through the roof because the supply of new bonds has also been strong--a reflection of the desire of many local and state governments to issue debt at these rates. “The supply would dry up if interest rates rose” and thereby offset some of the impact of the rate jump, said Reeves.
“That’s why we feel tax-frees have reasonably good upside potential, plus a real price floor.”
Even Reeves agreed, however, that intermediate-term muni funds might be a good compromise choice for many risk-averse investors--including those moving out of bank accounts into mutual funds for the first time.
“There definitely are good reasons to be in intermediate funds,” he said.
Long and Short of It
Municipal bond funds generally hold longer-term bonds than other fixed-income categories.
During periods of stable or declining interest rates, this is a good way to pick up extra yield and price appreciation. But when rates are rising, longer bonds are more likely to decline in value.
The average maturity of different fund categories, shown below, is a rough way to gauge the interest rate risk. Higher numbers suggest more potential volatility.
Fund type Average maturity California Municipal Bonds 20.8 years Other Single-State Municipal Bonds 19.3 years National Municipal Bonds 17.9 years Corporate Bonds 10.6 years High-Quality Corporate Bonds 8.9 years Low-Quality Corporate Bonds 8.3 years Treasury Bonds 8.3 years Government Bonds 7.9 years Government-Backed Mortgage Bonds 7.1 years World Bonds 6.2 years Adjustable-Rate Mortgage Bonds 2.7 years Short-Term World Bonds 1.1 years
Source: Morningstar Inc.
