Risks of Non-rated Municipal Bonds

According to the Investment News, four firms are managing high-yield municipal bond funds with more than 40% of their assets invested in non-rated bonds, a red flag for investors, according to a muni bond expert.

Invesco tops the list of the firms carrying non-rated bonds. More than 64% of the Invesco High Income Municipal Bond Fund (AHMCX) and 61.3% of the Invesco Van Kampen High Yield Municipal Bond Fund (ACTHX) are in such bonds, according to research provided by Morningstar Inc.

Nuveen Investments LLC’s High Yield Municipal Bond Fund (NHMAX) has 46.9% in non-rated bonds, while Waddell & Reed‘s Municipal High Income Fund (UMUHX) has 44.9%, and OppenheimerFunds’ Rochester National Municipal Fund (ORNAX) has 43%.

Given the continuing headline risk in the muni bond market, funds with such large allocations to non-rated bonds risk having to meet massive redemptions and could get stuck with having to sell these less liquid bonds at lower prices, he said.

Because the bonds tend to be thinly traded, it can often be difficult to price them, experts said. This is a risk with all muni bonds but even more so for non-rated bonds, said Matt Fabian, managing director at Municipal Market Advisers.

“When you have uncertainty about what the bonds are worth and managers reporting the value on the bonds, you need to make sure they aren’t exaggerating the value of the bonds,” Mr. Fabian said.

The Wall Street Journal reported that the Securities and Exchange Commission is investigating whether muni bond fund managers are overstating the value of the riskiest bonds in their portfolios, thus misleading investors. As part of the investigation, the SEC is looking into funds’ holdings of non-rated bonds, according to reports.

SMALL ISSUERS

Non-rated bonds aren’t inherently bad.

Often these issuers don’t apply for a rating, because it would be too expensive, given their size. The average size of these issuers is $21 million, according to Municipal Market Advisers.

Bonds also can be non-rated because they aren’t investment-grade or they have been pre-refunded.

“As long as advisers understand the funds’ diligence process on these bonds, they can be great opportunities,” said Alan Dalewitz, a senior vice president at Herbert J. Sims & Co. Inc.

Officials at Invesco, Waddell & Reed, OppenheimerFunds and Federated Investors Inc. said that they all have analysts devoted to researching bond issuers, and their research process includes continual monitoring as well as site visits to the issuers. Each of the firms assigns its own internal ratings to the bonds, and monitors those ratings, executives said.

“Our team of 10 credit analysts spend all of their time looking at non-rated deals,” said Troy Willis, a vice president and senior portfolio manager of the Rochester funds at OppenheimerFunds.

In many cases, the firm can do better research on the bonds than the ratings agencies, said Michael Walls, a vice president and portfolio manager at Waddell & Reed. He said that ratings agencies “do a good job of giving a snapshot in a given period of time.”

But Mr. Walls said the agencies don’t conduct audits on a quarterly, let alone more frequent, basis.

For example, Waddell & Reed invests in a lot of muni bond issuers that finance construction in the life care field, such as nursing homes, and has a person on-site making sure that subcontractors are within their budgets and abiding by the proper construction guidelines, Mr. Walls said.

Similarly, Invesco has 33 analysts dedicated to muni bonds, Lyman Missimer, head of global cash management and municipals at Invesco, wrote in an e-mail.

POTENTIAL TROUBLE

But even firms with the most prudent diligence process can run into trouble if there is another run for the exits by muni fund investors, as there has been over the past few months.

Muni bond funds have seen $25 billion in outflows over the past 14 weeks, due largely to fears about mass defaults in the muni bond market, according to Lipper FMI.

And now with mass protests in Wisconsin and other states over budget cuts, as well as the recent news of the SEC investigation into muni bond funds, some in the industry worry about an even bigger exodus. Just last week, Jeffrey Gundlach, founder of DoubleLine Capital LP, predicted a sell-off in munis.

“A manager’s analysis of the bonds in the portfolio can be 100% on,” Mr. Jacobson said. “But if shareholders bolt from a fund, that can drive down price, and the funds have to lock in those losses.”

If you have questions about municipal bond investments you made, the securities attorneys of The White Law Group may be able to help.  For a free consultation, call the firm’s Chicago office at 312-238-9650.

The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida. With over 30 years of securities law experience, including experience working at FINRA (f/k/a the NASD) and the SEC, The White Law Group has the expertise to help investors defrauded in securities, investment and financial business transactions.

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