Only a smattering of municipal bond mutual funds have managed to eke out positive totalreturns since mid-year, and the top five all have one thing in common - Joe Deane, amanaging director at Citigroup Asset Management Inc. in New York, structured theirportfolios to lessen the impact of rising interest rates.
The stance Deane took was a painful one during the first half of the year, as municipalbond yields plummeted to lows not witnessed in decades. Deane had reduced his fivefunds' sensitivity to interest rates and hedged them against a rise, causing theirperformance at first to slip to the near bottom of their respective Lipper Inc.categories.
But the cautious approach has paid off dramatically since municipal bond yields ascendedthis quarter. Only 10 municipal bond funds are so far producing positive total returnsfor the quarter, based on an analysis of the largest share classes for each fund,according to Lipper. The average share class experienced a loss of 2.94%.
Leading the pack on the positive side is Deane's Smith Barney Arizona Municipals fund,its A-class shares having produced a total return gain of 1.67% since the start of thequarter. The average Arizona fund, by contrast, is down 2.91%.
The return produced by the fund this quarter has propelled its total return for the yearto date to 2.79%, also the best in the category. During the first half, its 1.11% returnranked dead last among Arizona funds.
The second-best muni fund this quarter, according to the Lipper analysis, is the SmithBarney New Jersey Municipals fund, with a total return of 0.87%. The Smith Barney NewYork Municipals fund and the non-state-specific Smith Barney Managed Municipals Fund arethe third- and fourth-best performers overall, with total returns of 0.59% and 0.38%,respectively.
While California funds have suffered because of the state's political and budgetarytroubles, the Smith Barney California Municipals fund has managed to produce a totalreturn of 0.30% this quarter, making it the fifth-best muni fund overall. The averageCalifornia fund is down 3.68% since mid-year.
The California fund's secret is an aversion to bonds whose credit is somehow related tothat of the state, according to Deane. The fund has only a tiny position in Californiageneral obligation bonds, and most of its holdings are essential-service revenue bonds,he said.
The only other funds whose largest share classes produced positive returns since mid-year include South Dakota and North Dakota funds run by the Minot, N.D.-based IntegrityMutual Funds Inc., a Colorado fund run by Freedom Funds Management Co. in Denver, ashort-term fund run by the Milwaukee-based Strong Financial Corp. and a national fundrun by Calvert in Bethesda, Md.
The Smith Barney funds have been buoyed to the top not by sector-specific credit callsbut rather by a consistent strategy applied to all the funds that has allowed them toperform well even as bond prices have eroded.
Deane has adopted a strict diet for the funds, requiring higher stakes in cash, so thatthey own fewer bonds on which to take principal losses.
The funds can't own any zero-coupon bonds. Because they don't bear any returns untilthey mature, zeros are said to be more long-term - and thus more interest-rate-sensitive- than bonds with identical maturity dates that make periodic interest payments.
Bonds with coupons below 5% are also out of the question, because they will be difficultto trade in a higher-interest-rate environment, according to Deane. So are any bondstrading at discounts to their face value.
Discount bonds can "sink like a stone" when interest rates rise, Deane said. When thediscounts bonds trade at in the secondary market reach a certain level, the bonds beginto trade at depressed prices, because the gains a buyer would realize when they matureat face value are federally taxable as ordinary income rather than at the lower capital-gains rate.
Instead, the funds are investing in short-term and high credit-quality bonds, which areless sensitive to interest rate changes, Deane said.
When rates rose in 1999, Deane had also shortened his portfolios and bulked up in cash.But following the infamous Long Term Capital Management hedge fund collapse, he optednot to use futures contracts. Despite his defensive stance, share classes of Deane'sManaged Municipals fund showed up at the very bottom of the Lipper rankings by the endof 1999 and the funds' assets were left depleted by almost $1 billion.
This time, Deane said he is using futures contracts to offset losses. So far, cash flowhas been steady, he said. "We just wanted to have the most liquid and the mostconservatively positioned funds we could get our hands on," Deane said. Interest ratesseemed too low based on the state of the U.S. economy, he added.
"We just felt that when the marketplace broke from the levels that they drove it to,that this was going to be one of the all-time great down-trades in the history of thedown market, which it turned out to be," Deane said.
Over a period of nine weeks starting June 12, The Bond Buyer 20-Bond Index rose from to4.21% - its lowest level since 1968 - to 5.18% on Aug. 14. The 23% rise was the largestpercentage increase in the index level in 16 years. Historically, there have only beenthree periods in which the index has risen so much over such a short span of time sinceThe Bond Buyer began tracking the index on a weekly basis in 1946. Those percentageincreases occurred in 1987, 1980, and 1951, and the largest of these was in 1980 whenthe index rose 24.4%, to 9.44% on March 27 from 7.33% on Jan. 24.
"Once the market started going down, you were either defensively positioned or you werejust run over," Deane said.
Many portfolio managers have been performing a balancing act as they try to continueproviding income for their shareholders while limiting the price volatility of theirfunds, said Craig Vanucci, a director of fixed income at B.C. Ziegler & Co. inMilwaukee. Many investors buy shares specifically for the income they produce, he said.
For that reason, Deane believes rising interest rates may be beneficial to the marketover the long run.
The funds have recently been struggling to attract capital, and higher interest ratesmay make them a "very, very attractive area for people to look at again," Deane said. Bystocking up on cash, his approach will allow his funds to reinvest and benefit fromthose higher rates that much more quickly.
"We don't think the down market's over - we think it's just started," Deane said. Hepredicts the century's first great bear market in bonds could last until the end of2004.
