Muni Bond Funds Loaded With Unrated Bonds A "Red Flag"

Municipal bond funds are often thought to be safe investments, but be careful, especially with funds stuffed full of unrated bonds:

Nuveen Investments LLC's High Yield Municipal Bond Fund has 46.9% in non-rated bonds. Waddell & Reed's Municipal High Income Fund and the firm's Ivy Municipal High Income Fund have 44.9% and 39.15%, respectively, in non-rated bonds. OppenheimerFunds' Rochester National Municipal Fund has 43% in non-rated bonds, and its Oppenheimer AMT-Free Municipals Fund has 38%.

“I would say that anything with more than 20% in non-rated bonds requires absolute confidence in the management team,” said Eric Jacobson, director of fixed-income research at Morningstar. “Anything above 40% is a red flag.”

So, what's the problem with having so much of a fund's assets tied up in unrated bonds?:

Non-rated bonds tend to be small in size and thinly traded. The average size of these issuers is $21 million, according to Municipal Market Advisers. Given the continuing headline risk in the municipal bond market, funds with such large allocations to non-rated bonds risk having to meet massive redemptions and getting stuck with having to sell these less liquid, non-rated bonds at lower prices, Mr. Jacobson said.

Another trouble with these bonds is that since they tend to be thinly traded, it can often be difficult to price them, experts said. This is a risk with all municipal bonds but even more so for non-rated bonds, said Matt Fabian, managing director at MMA.

“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.

According to Investment News, here are the top-10 muni funds with the highest percentage of unrated bonds:

Invesco High Income Municipal A: 64.3%
Invesco Van Kampen High Yld Municipal A: 61.3%
Nuveen High Yield Municipal Bond A: 46.9%
Waddell & Reed Muni Hi-Inc A: 44.9%
Oppenheimer Rochester National Muni A: 43.0%
Pioneer High Income Municipal A: 41.1%
Lord Abbett High Yield Municipal Bond A: 40.2%
Ivy Municipal High Income I: 39.2%
Oppenheimer AMT-Free Municipals A: 38.0%
Federated Municipal High Yield Adv F: 35.3%

It is important to note that most if not all of these funds are high yield funds. Oppenheimer's California Municipal Bond Fund, which purported to be a more conservative, capital preservation bond fund, had over 60% of its assets invested in unrated bonds as of December 31, 2008, according to Lipper.

That's one big reason that when the financial crisis hit in 2008, Oppenheimer's California Municipal Bond Fund lost over 46% of its NAV while the average loss among funds in the same Lipper Classification only lost 11% over the same time period.

At the very least, Oppenheimer should have disclosed the enormous risks that it was taking with investors' money.