Obvious rewards, not-so-obvious risks in `junk' muni bond funds

After what happened to the municipal bond market in April and May, ``junk'' munis would seem like the last place anyone would put his money. Fed by uncertainties over tax reform and interest rates, municipal bond prices plummeted almost 13 points, or about $650, on $5,000 face value of debt. Investors in some municipal bond mutual funds watched the values of their portfolios drop more than 10 percent in a couple of weeks. Since then, the day-to-day volatility of these markets has been much higher than it was last year, when the debate over tax reform made the future of municipal bonds even more uncertain.

Why, then, would anyone consider putting money - either directly or through a mutual fund - into a collection of bonds that can't get anything better than the fourth best bond rating, or can't get a rating at all?

The simple answers are higher yield and the potential for more profits, if enough of the bonds show a decent growth in price. These reasons have apparently been enough for many investors and mutual funds. Several new funds have opened up in the last two or three years, with terms like ``high yield'' and ``aggressive tax-free'' as part of their names.

Like all new investments, however, the amount of money that comes into them and the amount spent to promote them are far greater than the understanding about how they work and how risky they might be.

Bonds that carry no rating may or may not be riskier than those that carry a fairly low rating, like a BBB from Standard & Poor's, or a Baa from Moody's.

``There are two different reasons to come to the market unrated,'' says George Friedlander, a senior research analyst at Smith Barney, Harris Upham & Co. ``The first reason is that you expect to get a lousy rating. The second is that you're too new or too small to have a rating yet.''

Many of the new high-yield muni bond funds, in fact, specialize in unrated bonds that are issued in amounts considered too small to be rated by the major agencies, usually under $10 million. These days, says Terry Trim, vice-president at American Portfolio Advisory Service, a subsidiary of Van Kampen Merritt, many of the bonds are issued to pay for things like small hospitals, limited-care nursing homes, retirement homes, and small multifamily projects.

``Some of the projects are so small they wouldn't qualify for a triple-B'' rating, Mr. Trim says. ``But they may still be good, with plenty of room for improvement.''

Because these projects are often small and because the bonds aren't rated, they have to offer higher yields to sell their paper. Currently, Trim says, unrated bonds are paying 1 to 1 percent more yield than munis with a BBB rating. Compared with bonds with a higher rating, the yield differences are even greater.

The fund Trim manages now has a yield of 7.58 percent, compared with 6.91 percent for the company's fund of insured and rated municipal bonds.

The trick to keeping a fund's yield up and its net asset value, or price per share, growing at least at a stable rate is careful selection. The new attention being given to unrated bonds has provided plenty of work for specialists who analyze their risk and soundness.

``There are over 20 high-yield funds,'' says Mr. Friedlander at Smith Barney. ``Some are good and some are not so good. Not all non-rated paper is created equal, and it's up to the manager to figure out which is which.''

``Even where bonds are rated we do an analysis,'' says Anne Punzak, portfolio manager of the Fidelity Aggressive Tax-Free Fund. ``We don't just rely on the ratings.''

The greatest danger with high-yield funds is that one or more of the bonds in the portfolio will go into default. While this might not affect the fund's overall yield very much, it could have a dramatic effect on the net asset value, and very quickly erode an investor's principal.

``There's always going to be some clinkers,'' Friedlander says. ``The key is to keep them as small a part of your portfolio as you can.''

Some people would just as soon avoid high-yield munis altogether. ``The normal muni bond market, the plain vanilla stuff, has been a wonderful, wonderful market. It's provided good yields without a lot of risk,'' says John Sebastian, executive vice-president at Clayton Brown Associates, a municipal bond broker.

`I think any investor going into a high-yield fund has got to be very cautious and careful and understand the makeup of the portfolio, and fully understand the risk/reward ratio,'' adds Thomas Vaughan, a senior vice-president at Clayton Brown.

Investors who do understand the risks and plan to keep these funds as a small part of their investment portfolio should look for fund managers with plenty of experience in finding unrated bonds that don't turn out to be clinkers.

``I'd ask how many defaults they've had in their portfolio,'' Trim says. ``How many analysts do they have to review projects? Only then would I look at performance numbers. There's an old saying: `It's not what you earn, it's what you keep.' That's certainly true here.''

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