Sometimes, lessons are costly; sometimes, they're cheap. For investors in municipal bonds and municipal bond mutual funds, what appeared to be a costly lesson may turn out to be fairly cheap. Many of these people, especially those who first tried bond funds as one of the few tax breaks left after tax reform, have been getting jolted lately.
In a few days around mid-April, bond prices fell 5 percent or more. The fall was attributed to several factors, including the weakening United States dollar and worries about higher inflation. When this happened, investors started asking for higher yields on their bonds. Bond prices, which move in the opposite direction, headed south.
A similar slide came earlier this week, when bond prices fell 1 percent on concerns that this week's Treasury refunding may not be well-received, which would push up rates more.
The problem has hit all sectors of the bond market, including mortgage-backed securities, but it's been especially tough on municipal bonds, because many dealers already had an oversupply of unsold issues.
For the municipal bond funds, their yields went up a point or so, but their share prices, or net asset values, fell 4 to 9 percent in less than two weeks.
``It was Armageddon,'' says John Sebastian, executive vice-president of Clayton Brown & Associates Inc., a municipal bond broker in Chicago. Not all funds were affected to the same degree, he says. ``The funds that were hit the hardest were the high-yield funds investing in non-rated or lesser quality bonds.''
``It was pretty ugly there for a while,'' agrees Robert Zubak, manager of the long-term municipal bond department at Van Kampen Merritt, a brokerage. ``A lot of people panicked.''
Some of those who panicked made quick calls to their fund sponsors and switched their money to tax-free money market funds or, if one was not available, to taxable funds, to wait out the turbulence. Unfortunately, many of those calls were made after the funds had dropped 4 or 5 percent.
``People sold at the bottom and now they have to buy again when the funds are going up,'' says Brian Mattes, vice-president of the Vanguard Group in Philadelphia. ``Having already lost as the fund went down, they were three-time losers.''
Still, after the Treasury auction this week, people should ``very definitely'' think about calling their funds back and returning to municipal bonds, says John Noonan, vice-president and manager of fixed-income investments at John Nuveen & Co., a municipal bond broker.
Those earlier telephone switches, in fact, only added to the weak-bond problem, because they forced portfolio managers to sell even more bonds, which further eroded their prices.
Even more bonds had to be sold when people paid their taxes.
``Many [fund managers] did not anticipate how much money would be withdrawn to pay Uncle Sam,'' Mr. Noonan said. Since many of these funds have checkwriting privileges, the checks taxpayers stapled to their 1040 forms came from their municipal bond funds.
``That took an awful lot of money out of the muni funds,'' he says.
One group of investors who were not affected at all by the turmoil bought municipal bonds directly and plan to hold them until maturity. ``People who bought bonds to clip the coupons or collect interest weren't bothered,'' Noonan says. ``But if they did it to play the market, it was something else.''
There are some lessons to be learned form this debacle.
First, with all bond funds, highly touted yields are only part - often less than half - of the story. You can make even bigger gains if the net asset value (NAV) climbs smartly, just as you can take even bigger losses when the NAV goes down with bond prices.
Second, don't panic. In most cases, when the bond markets take a hit like this, prices usually recover, though not as quickly as they went down.
Finally, as with all investments, there is an element of risk. You have to accept that risk when you get in, but you also have to pay attention. If you start to see some losses, find out why it's happening, then decide if you want to stay or find safety and possibly better returns somewhere else.
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