Morningstar Advisor - Summer 2008 - 74

Bond Fix struggling Jefferson County, Ala. Moreover, the city of Vallejo in Northern California has recently filed for Chapter 9 bankruptcy. While defaults are rare, credit-rating downgrades and issuer-specific troubles can cause bond markdowns that can injure a mutual fund’s returns, sometimes greatly (see sidebar for an example). This possibility is particularly concerning when the economy slows, or goes into a recession. Declining income, sales, and property tax receipts can cause significant budget shortfalls. Additionally, while the demand for municipal bonds might be strong for the time being because valuations look attractive, it’s unclear whether the demand seen from the leveraged purchasers will return or stay on the sidelines. Excellent opportunities still exist in this market, but it is vitally important that advisors select municipal funds that boast strong research teams whose due diligence can help navigate past credit problems when they arise. Advisors would do well to look at the Morningstar Fund Analyst Picks list near the back of this magazine to find a listing of our favorite municipalbond offerings. All these funds are run by shops that excel in credit research and place a high premium on protecting shareholder capital. K Lawrence Jones is a senior mutual fund analyst with Morningstar. Morningstar Analyst’s Take The credit troubles of Calvert Tax-Free Reserves Limited-Term CTFLX weigh on its prospects. Beginning in 2006, a series of credit problems struck this fund, hurting results. For example, the fund’s loss of 1.75% in 2007 was the worst showing in the muni-national short-term category, and the year was the worst period for the fund in its 26 years. The trouble started when unrated bonds issued by the West Virginia Economic Development Authority to fund a conference center defaulted, partly because government support for the privateactivity bond was withdrawn. Then, in mid-2006, unrated bonds issued to finance an assisted-living facility in Tarrant County, Texas, were marked down after declining occupancy rates put the viability of the project into question. Finally in 2007, bonds issued by a Tulsa County, Okla., multifamily housing authority were also marked down, as construction delays and low occupancy rates hurt the unrated debt. Moreover, while the credit problems raise serious questions about the adequacy of the credit-research process here, we’ve also been increasingly concerned by the fund’s significant outflows. This could cause trouble with illiquid positions, should management be forced to either sell bonds at depressed prices or unsettle the portfolio in an attempt to avoid selling. Indeed, in mid-2007 the fund filed a regulatory statement revealing that assets in illiquid securities exceeded its 15% mandated limit. In fact, the percentage was recently as high as 30% in illiquid holdings, prior to the team working out of troubled bonds to reduce the stake to 22%. We’re glad the team resolved the Tarrant County and Tulsa County credit problems (ultimately recovering 55% and 65% of investors’ original capital, respectively), but uncertainty still surrounds the West Virginia bonds (recently trading at $0.29 on the dollar) and overall fund prospects. We’ve added the fund to our Analyst Pan list to reflect our concerns. By Lawrence Jones, June 4, 2008 Free. Quarterly. Don’t miss an issue. Subscribe today! Call 888 235-0828 or visit MorningstarAdvisor.com 74 Morningstar Advisor Summer 2008 Magazine Ad _ VR _ 8 July 2008 _ Final

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Morningstar Advisor - Summer 2008

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