Taxing times for tax-exempts

Municipal bond funds' performance hurt by rate increases

For municipal bond funds, this year has been trying indeed. Like other fixed-income securities, tax-exempt portfolios are suffering through one of the worst bear markets for bonds since 1993. Rising interest rates are the main culprit, as some fund managers holding longer-term debt turned in less-than-stellar performances.

The numbers aren’t too pretty. National munici-pal long-term bond funds had an average cumulative total return of negative 3% for the nine months ending September 30, according to Chicago mutual fund research firm Morningstar. The top five municipal bond funds all had negative returns for the period as well, but still outshined their peers on the bottom rungs.

Portfolio managers who had the foresight to shorten the maturities of their funds have done better than their peers, says Eric Jacobson, senior analyst with Morningstar. Some of the other strategies muni bond portfolio managers used to beat the competition included selling lower-rated securities, then purchasing higher-rated bonds, and buying bonds cheaper when there’d been a glut in certain sectors.
For James Welch, portfolio manager of the $200 million New England Municipal Income Fund in Boston, long-range planning helped the performance of his fund.

Welch explains that he began to change the composition of his portfolio more than a year ago. One catalyst: in the fall of 1998, the Fed lowered interest rates to avert a global financial crisis despite the fact there was evidence of too much strength in the domestic economy. “At that time, it was a perfect opportunity to realize great sales in bonds,” he says.

He reduced the number of lower-quality bonds-those rated triple-B or lower, for example-and increased the amount of triple-A insured bonds in his portfolio. The highest rating for bonds is triple-A, and more than 50% of new municipal issues carry insurance to protect investors from a default or interruption in interest payments on the bonds.

Welch’s strategy helped the fund record a cumulative total return of -0.99%, higher than the average for national municipal portfolios and landing it in first place, according to Morningstar. In addition, the 12-month yield on the fund through September 30 was 5.36%, higher than the average yield of 4.96% in the category.

At least one fund, the $68 million Great Plains Tax-Free Bond Fund, benefited from the unusual makeup of its portfolio, according to Robert A. Campbell, certified financial advisor, vice president and portfolio manager of the fund, sponsored by First Commerce Bancshares in Lincoln, Nebraska. Although classified as a national municipal bond fund, the portfolio is actually an intermediate fund, with an average maturity of about 8.8 years. Also, as much as 60% of the fund is invested in Nebraska credits, says Campbell.

“We cater to a Nebraska clientele,” he explains. “Because of the limited issuance [in Nebraska bonds] and the need for prudence, we’ve decided to stay in the national market,” since it’s in the best interests of the fund’s shareholders.

Campbell also notes that his fund is income-oriented. In other words, he looks for issues with higher coupons-the interest paid to investors on bonds. And he focuses

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