Radical Guide to Bonds: 2 Points Related to Municipal Bond Funds

Municipal bond funds may work for you.  Depending on their expenses and costs, they may give you the right amount of exposure to the municipal bond market. 

In this chapter, we want to highlight two points related to municipal bond funds.  (Some of these generalize to other bond funds, such as high yield corporate bond funds).  Here’s what you should keep in mind:

  • Find out how the fund prices its holdings.  If you’re in a municipal bond fund, especially a high yield municipal bond fund, many of its bonds may not have traded for months.  Moreover, the manager will have a lot of leeway to determine the value of individual bonds. 

Consider this scenario.  Either the market or a credit event has pounded the value of the fund’s municipal bond holdings.  The manager wants to cover up a deteriorating situation.  By colluding with a so-called independent pricing service, the manager reports unrealistic market prices.  The manager has propped up the fund’s NAV.

An unrealistic scenario?  In 2000, this scenario happened to two of the Heartland Group’s high yield municipal bond funds.  When the charade was up, the municipal bond holdings were repriced downward and the NAV on the two funds lost 50-75% of their value in a single day.

  • Tax exemption is an ever-shifting field. The Tax Reform Act of 1986 included private-purpose bonds under the tax exemption umbrella.  These bonds are municipal revenue bonds funding specific projects with a public purpose.  For example, you will see these bonds issued in support of housing, airport, hospital or other like projects. 

The IRS has begun to challenge the tax-exempt status of several of these bond issues.   If the IRS suspects the bonds lack a public purpose, then the tax exemption status is, at best, shaky… and may be revoked.

The IRS challenge can have two immediate effects. 

One, if you are holding a municipal bond fund, and one of its bonds is under scrutiny, its value drops immediately.  Second, if the tax exemption is revoked, you may owe more in taxes as a fund shareholder.  (That depends on whether the managers pick up the tab for the higher taxes or not).

We included this chapter as nothing other than a cautionary tale.  Funds work.  In fact, they may be the best investment for you. 

Before investing in municipal bond funds, you will need information.  If you are interested in a high yield municipal bond funds, then your information requirements will sharply increase. 

Ask what the percentages of AMT and private-purpose bonds are in the fund. Get a prospectus and see how the fund prices its holdings.  Call the fund’s customer service desk and get your questions answered.  Speak to the portfolio manager and ask how the portfolio is priced.  Ask about pricing evaluations. 

If they can’t answer your basic questions, go elsewhere.  You need to get this information.

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June 3, 2005 | Permalink

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