Inside 2008's Muni Meltdown

According to the wags of Wall Street, in a crash, the only things that are up are correlations. In other words, the standard benefits of diversification don't seem to accrue during a financial collapse; every asset class, from stocks, to bonds, to real estate, seems to do the same thing at once--namely, decline. In 2008, the wags' quip played out painfully, as every asset class except for U.S. Treasury bonds dropped significantly, even if non-Treasury, high-quality bonds generally didn't lose as much as stocks.

Perhaps the most painful and surprising aspect of the recent market tumult has been the decline in municipal bonds. In this issue, we'll examine why "munis," as they are called, had such a rough year in 2008, and how the prospects for American's muni funds are shaping up.

Why Even Munis Didn't Hold Up Last Year
Munis are the bonds of state and local governments, which pay interest that's free from federal taxes and sometimes free from state and local tax for residents of the issuing state. There are "junk" or below-investment-grade munis to be sure ( American Funds High-Income Municipal Bond (AMHIX) owns a slug of them), but many munis are AAA rated and insured to boot.

Still, despite strong credit ratings and insurance coverage, munis didn't simply underperform; they failed rather miserably compared with Treasuries in 2008. For the year, the Barclays Capital 20+ Year US Treasury Index rallied 34%, while the Barclays Capital Municipal Long 22+ Index dropped a breathtaking 15%. Despite U.S. Treasuries being the most credit-worthy investment around and the investment of choice of fear-wracked investors, munis are no credit slouches themselves, making this disparity in performance striking. One might have easily expected munis to do well or at least hold up better than they did in a difficult credit environment.

Additionally, munis' tax-free interest means that there is a steady demand for them from wealthy individuals. Indeed, although munis typically pay lower nominal yields than Treasuries because of their tax-free interest, that yield often winds up being higher on an aftertax basis than that of Treasuries to individuals in the highest tax brackets.

So, why did instruments with such belt-and-suspenders safety and seemingly steady demand fail to be attractive in a time of stress? Why did munis crash in 2008 to the point where their nominal yields became higher than those of Treasuries, prompting some seasoned bond managers to buy them even in taxable-bond funds?

The insurance factor is the first reason for munis' 2008 swoon. Although muni defaults weren't a major factor, credit risk reared its head in the form of the major insurers of municipal bonds-- Ambac ,  MBIA (MBI), FGIC, and others--having their financial ratings cut as a result of dabbling in insuring low-quality mortgages. A unit of  Berkshire Hathaway (BRK.B) has since stepped in to take business away from the embattled insurers, but revelations of their troubled mortgage business exacted a toll on munis. Additionally, fears abound that municipalities themselves appear to be struggling with lower tax bases in the current recession. Third, the trading of auction-rate securities (long-term munis whose interest rate is set on a shorter-term basis through frequent auctions) nearly halted at the end of February, when failing brokers couldn't support the auctions.

Finally, fancy instruments called tender option bonds, sometimes called "inverse floaters," have played a significant role in gyrating the muni markets. Not every fund owns these instruments, and we can't find them in American's municipal funds. However, their existence and their use by hedge funds served to throw the muni market into tumult.

A TOB is created when an investment bank takes money from an investor (usually a hedge fund), matches it with an amount of borrowed money, and takes the entire pool and buys a municipal bond. If the yield from the municipal bond exceeds the cost of borrowed money, you wind up with a kind of municipal bond on steroids. It's attractive to create these instruments with municipal bonds precisely because muni credit ratings are typically strong, which makes their interest payments dependable. The linchpin of the arrangement, however, is being able to borrow at a rate lower than the muni's yield, which basically means consistently rolling over short-term loans to finance the purchase of the longer-term muni.

TOBs are called inverse floaters because, as long-term interest rates fall, the instruments enjoy a kind of supercharged effect compared with what bonds normally experience. The prices of existing bonds normally rise when interest rates fall, because their fixed coupons are higher than those of new issues. So an instrument, such as a TOB, that's producing even more yield, thanks to the borrowed money used to purchase additional bonds, is even more attractive at a time when rates are falling. On the other hand, when rates go up, the spread between the cost of borrowing and what the bond is paying narrows, which hurts the investment considerably.

Moreover, if the ability to borrow dries up, the rationale for the entire TOB structure evaporates, and the bonds bought with borrowed money have to be liquidated. This is what happened to many hedge funds in 2008; financing dried up, and they were forced to liquidate the muni positions, dumping them onto the market en masse. Consequently, muni prices got pummeled from the glut of munis on the market, and mutual funds suffered whether they owned fancy TOBs or not. American's three national (non-state-specific) muni funds suffered accordingly, with  American Funds Limited-Term Tax-Exempt Bond (LTEBX) shedding a little more than 1%,  American Funds Tax-Exempt Bond (AFTEX) dropping 7%, and  American Funds High-Income Municipal Bond (AMHIX) plummeting 19%.

American's Muni Funds' Prospects
First, none of American's national muni funds owns TOBs or other derivatives as far as we can tell after examining the funds' portfolios, annual reports, and statements of additional information. American tends to run its bond funds in a straightforward fashion, avoiding derivatives and simply buying cash bonds. Nevertheless, the firm's funds tended to underperform their categories in 2008, with all finishing in the bottom half of their respective peer groups. The reason for this is that American seeks to add value by taking some credit risk or overweighting bonds with lower credit ratings that its analysts think are mispriced or more creditworthy than their ratings might indicate. We think American's credit expertise bodes well for all three of its national muni funds.

 American Funds Limited-Term Tax-Exempt Bond (LTEBX)
This is American's least interest-rate-sensitive fund, with an average duration of 4.3 years. However, it still winds up in Morningstar's muni-national intermediate category. It will experience a roughly 4% decline in net asset value for every percentage point rise in interest rates. The fund also has about 13% of its assets in bonds rated BBB, which is among the highest in the category, so it has some credit risk as well. Investors worried about inflation and interest-rate rises gyrating bond values as the economy recovers should own this fund.

 American Funds Tax-Exempt Bond (AFTEX)
This is American's most straightforward national muni fund. Its average duration is 6.7 years, making it more interest-rate-sensitive than Limited-Term Tax-Exempt. However, it will also provide more yield. The fund holds around 16% of its portfolio in bonds rated BBB; the portfolio, like its sibling's, has among the highest concentration in the muni-national intermediate category. It also has another 18% in A rated securities. Bonds rated BBB are the lowest rung of what's considered to be investment grade. They tend to give a bit more yield, however, in exchange for their credit risk, and they can also provide some capital appreciation if their credit prospects improve. Investors unwilling to make dramatic credit or interest-rate bets should own this fund.

 American Funds High-Income Municipal Bond (AMHIX)
This is American's most aggressive and opportunistic fund in terms of credit risk, but it will also provide the most yield. Around 60% of its portfolio is in unrated bonds, and another 12% is in bonds rated BB and BBB. If the credit crisis deepens, this fund will suffer, but as the economy recovers, this fund has the potential to bounce back harder than its siblings. Although the fund hadn't owned auction-rate securities prior to the crisis of 2008, the dislocation in the ARS market allowed the managers to purchase some at what they think are attractive prices. The managers have written that they expect the bonds to be called before they mature, but they are willing to hold them until maturity in any case. A dollop of this fund will be fine for most investors.

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