Municipal bond funds feel the crunch

No corner of the market is safe from the volatility created by the credit crisis and mortgage mess -- not even state and municipal bonds.

By KARA McGUIRE, Star Tribune

Last update: March 15, 2008 - 11:05 PM

Dull but dependable and tax-free to boot. That's the appeal of municipal bonds and muni-bond funds. But the credit crisis is leaving no asset class untouched.

Municipal bond yields rose at the end of February, causing returns on Minnesota municipal bond funds to nose-dive to a level not seen since 2000.

According to Lipper, the cumulative total return in February for Minnesota Municipal Debt Funds was minus 4.38 percent.

"Some of the turmoil in the mortgage market has created investment volatility in some of the unlikeliest places," said Colin Lundgren, a fixed-income portfolio manager with RiverSource Investments in Minneapolis.

It all came to a head when fears about the financial security of bond insurers caused muni investors to demand a higher premium for the perceived risk of a municipal bond with potentially worthless insurance, despite the fact that such bonds rarely default. Some hedge-fund investors sought redemptions, prompting a sell-off of municipal bonds in order to raise the cash. This flooded the marketplace with cheap, high-quality tax-exempt bonds at a time when demand just wasn't there, driving prices down and yields up.

That left muni funds holding portfolios of high-price bonds.

The storm was short-lived, although the muni market still is picking up the debris. From Feb. 29 through March 12, Minnesota funds gained 2.53 percent; the funds are down about 1 percent for the year.

Portfolio managers insist the underlying bonds are sound and that external factors caused the whirlwind. But that's little consolation for investors who thought they were invested in a staid and steady asset class.

Debra Sit, a municipal bond portfolio manager for Sit Investment Associates in Minneapolis, has told concerned investors that municipals will leave the spotlight once the credit markets stabilize.

When that will be is anyone's guess. That's not to say that investors seeking safety should avoid Minnesota's tax-exempt bonds.

Bruce Floberg, RBC Wealth Management senior municipal bond analyst, said that compared with other states, Minnesota public finances, at both state and local level, are "better than average."

Considering the trouble with bond insurers, he'd stick with higher quality Minnesota bonds such as general obligation bonds, revenue bonds with specific revenue sources such as water and sewer, and Minnesota school district bonds.

What's more, municipals tend to better weather recessionary conditions than corporate bonds, Sit said.

However, the real attraction is how cheap municipal bonds are compared with U.S. Treasuries.

Lowry Hill Private Wealth Management investment principal Martha Pomerantz first spotted high-quality municipal bonds yielding as much as, if not more than, Treasuries last summer.

"Because there's been a flight to quality, everyone's bought U.S. Treasury bonds. And since those Treasury bonds have been in demand, they've become expensive and driven the yield down," she said, to the point that "we don't want to buy them."

Munis are even being scooped up by taxable bond gurus such as Pimco's Bill Gross.

Take this example of a municipal bond yielding 117 percent of a Treasury: A Hennepin County General Obligation (Aaa/AAA-rated) priced last week and maturing in December 2013 offered at a 2.98 percent yield compared with a U.S. Treasury bond of nearly the same duration currently yielding 2.54 percent.

The after-tax return on that Treasury for a Minnesotan in the 35 percent tax bracket would be 1.65 percent compared with the 2.98 percent muni. Yields on good quality munis of longer duration are even higher. The spread is large enough even for taxpayers in lower brackets to benefit.

Kara McGuire • 612-673-7293