Morningstar Advisor - Summer 2008 - (Page 72)

Bond Fix With Munis Feeling the Pain, Some Opportunities Arise By Lawrence Jones Just make sure your municipal-bond funds have the wherewithal to steer clear of credit problems. From August 2007 to March, as fallout from the subprime-mortgage meltdown and the liquidity crisis rained down on the economy, the municipal markets suffered one dramatic jolt after another. The markets were depressed by a crisis of confidence in the creditworthiness of municipal-bond insurers, the failure of auctionrate securities markets, and significant sales of municipal bonds by highly leveraged market participants. Tom Metzold, the 15-year veteran manager of Eaton Vance National Municipals EANAX, a muni-national long-term fund that we recommend, told me that middle to late February was the single worst period of municipal performance he had ever witnessed. The data, and conversations with other muni managers, bear Metzold’s assessment out. But in addition to presenting plenty of risks and pitfalls, this market dislocation also afforded muni-bond investors with a buying opportunity unmatched in many years. Let’s examine what occurred in the muni markets, how these events produced attractive investment opportunities, and what risks could still unsettle these markets going forward. Technical- and Liquidity-Driven Trouble Unsettles Munis Wall Street trading desks and hedge funds that focused on municipal arbitrage strategies to borrow short-term debt and invest it heavily in long-term municipal bonds. This yield-curve dynamic soon changed, however. As the subprime meltdown and liquidity crisis grew worse as the year wore on, creating volatility and price declines in other regions of the fixed-income markets, risk-adverse investors—in a classic flight to quality—shifted assets away from sectors that were perceived to be troubled and toward areas thought safe. In an effort to reduce risk, and in many cases to meet margin calls, these traders and hedge funds aggressively sold long-term municipal bonds. As they did, the typical relationship between munis and Treasuries broke down; prices of municipal bonds declined as the prices of Treasury bonds (used to hedge the muni exposure) rose, intensifying losses. The pressure on long-term munis is illustrated well by looking at index returns for February, one of the worst months of muni volatility. For that month, the Lehman Brothers 20-Year Municipal Bond Index suffered a whopping 6.77% loss, while the Lehman Brothers 3-Year Municipal Bond Index was down only 1.34%, an effect that also hurt mutual funds invested more heavily on the long end of the yield curve. Added to this dramatic selling was the failure of the muni auction rate securities market, downgrades and fears over the financial condition of many monoline bond insurers, and a significant steepening of the muni yield curve. The steepening of the muni yield curve put added pressure on funds such as Eaton Vance National Municipals that purchase longmaturity bonds. It’s not surprising, then, that February represented the fund’s worst calendar month on record. Though these events caused significant losses for many funds, the episode produced compelling investment opportunities. Opportunities Abound in Munis Since late 2007, we’ve been pounding the table for investors to consider adding to their municipal portfolios. Senior mutual fund analyst Paul Herbert made the case (both in a November Morningstar Mutual Funds commentary and in the February edition of Morningstar FundInvestor) that municipal-bond issues looked attractively valued relative to comparable Treasury bonds. PIMCO has also forcefully argued for munis. “The dislocation that resulted in the municipalbond market brought municipal ratios versus Treasuries to their highest level on record,” said a recent PIMCO commentary. “At one point in February, the 30-year-AAA-rated-municipal-to-30-year-Treasury (yield) ratio reached over 120%.” The typical long-term yield ratio between comparable munis and Treasuries is 80% to 85%. Muni yields tend to be lower Because the municipal-bond yield curve remained positively sloped in the first half of 2007—in contrast with the flat, and occasionally inverted, Treasury yield curve—it paid for 72 Morningstar Advisor Summer 2008

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Morningstar Advisor - Summer 2008 Contents Letter from the Editor Contributors Inbox College Planning: Solutions and Concerns ETFs: The Next Chapter Engineering Financial Advice Investment Briefs Flexible vs. Style-Pure Managers: The Evidence Forging a New Commodity Index Work Your Way Through College Planning Sizing Up the Options Best and Worst 529 College-Savings Plans A 529 Travel Guide 10 Tax-Smart Tips for College-Savings Planning Global Dialogue How Sequoia Cranks Out Good Returns Year After Year The Many Layers of David Winters Living on the Edge Stocks to Buy Once a Decade With Munis Feeling the Pain, Some Opportunities Arise Health Care Provides Shelter from Economic Storm Help Your Clients Get More Out of Their Bond Portfolios Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar New on MorningstarAdvisor.com Closer to Fine

Morningstar Advisor - Summer 2008

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