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Lessons From the Muni-Bond Sell-Off

They're neither new nor novel.

Eric Jacobson, 03/03/2011

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It's been an awful time for the municipal-bond world during the past several months, with one headline after another causing investors to question their faith in the once nearly gilt-edged market. Morningstar's Miriam Sjoblom has been following those developments closely, and there's ample reason to believe there's a lot more smoke billowing than fire burning.

While clearly painful for many investors, the sell-off that gripped the market from early November to late January carried some important warnings that had very little to do with the mania and fears of imminent waves of defaults.

Going Long
The first was an old one that seemed to elude many muni investors, based on the number who began to flee only after the trouble began.

Despite all the muni-market hubbub, the majority of pain felt by investors across the market was driven by a good old-fashioned spike in Treasury yields. Although the much-publicized muni-market warnings of Wall Street analyst Meredith Whitney on 60 Minutes chafed the market in December, the sell-off actually started earlier thanks to increasing worry about the effect of the Federal Reserve's so-called QE2 program. Shorthand for a second round of "quantitative easing," the Fed telegraphed its intent to continue purchasing bonds in the open market with hopes of sparking growth--and some inflation.

That news quickly changed market expectations for the latter, and Treasury bonds sold off. Bellwether 10- and 30-year U.S. Treasury bonds tumbled 5.4% and 8.2%, respectively, from November through January according to Barclays Capital, and that put pressure on the muni market. The average long-term national muni fund fell 5.9%.

Of the 15 muni funds with the worst losses between Nov. 1, 2010, and Jan. 31, 2011, that also boast assets of more than $1 billion, nearly every one carried a duration meaningfully longer than those of its comparable peer groups or indexes. They included flagship investment-grade funds such as Oppenheimer AMT-Free Municipals OPTAX, Eaton Vance National Municipal Income EANAX, and Lord Abbett National Tax-Free Income LANSX, with losses ranging from 7.5% to 11.8% for that stretch.

On Borrowed Bond
In a handful of those cases, the funds' long-maturity profiles were helped along by a dose of leverage. Very few have been using portfolio-level borrowing or off-balance-sheet derivatives such as futures, forwards, and swaps, all of which have become popular among taxable-bond funds. The most common use of leverage in muni funds involves an inverse floating-rate bond structure called a Tender Option Bond trust. TOBs allow funds to borrow money at very short-term, tax-free rates and invest the proceeds in long-maturity bonds with much higher yields, pocketing the difference.

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