(Bad) News on Heartland Advisors' high risk municipal bond funds.
November 5, 2000
Splash of Cold Water for Bond Market
By DANNY HAKIM
In March, Stephen J. Zaslaw invested $3,000
in a high-yield municipal bond fund. Mr.
Zaslaw, 55, a software engineer who lives in
Cream Ridge, N.J., near Trenton, expected some
volatility. After all, high- yield — a k a junk —
bonds pay higher yields for a reason. In the case
of high-yield munis, they represent loans to
finance municipalities or municipal projects that
have low credit ratings or no credit ratings at all.
Still, a bond fund is a bond fund and not, say, an
Internet stock fund. At least, that is what Mr.
Zaslaw and most investors assume. But when
Mr. Zaslaw checked his portfolio on Friday, Oct.
13, and found that his $3,000 had largely
evaporated, he was left bewildered.
"What was three thousand and something was
now less than $1,000," he recalled last week. "It
scared the heck out of me."
Unfortunately for Mr. Zaslaw, this was no glitch by his brokerage firm. It
was an October surprise that has left the mutual fund industry wondering
about the reliability of municipal bond pricing and about what role, if any,
high-yield muni bond funds should play in an investor's portfolio. Some in the
business, however, say the episode raises more questions about one firm than
about this investment category.
Mr. Zaslaw's investment manager was Heartland Advisors, a Milwaukee
company with $2.3 billion under management. On Oct. 13, the firm
announced that its Heartland High-Yield Municipal Bond fund had fallen more
than 70 percent that day, after a change in the method used to assign values
to its bonds. The collapse left it as the year's worst-performing mutual fund
in any category, according to Morningstar Inc. — trailing even the worst of
the Internet funds. A second fund, Heartland Short Duration High-Yield
Municipal, fell 44 percent that day. At the end of the day, the two funds' total
assets amounted to $58 million, down from $120 million.
The Securities and Exchange Commission is investigating, Heartland said, and
shareholders have filed two suits against Heartland and one of the fund's
managers, Thomas J. Conlin, who departed the firm for what were described
as personal reasons a few weeks before the revaluation. In a statement, Mr.
Conlin said, "My resignation from Heartland was neither a cause nor effect of
the funds' declines."
An executive at a prominent bond investment management firm, Pimco
Advisors, said the Heartland matter reinforced doubts about whether the risks
of high-yield municipal funds were worth the potential rewards. "I just don't
believe that a fund comprised strictly of high-yield munis makes sense for
most investors," said Mark McCray, who manages $2.1 billion, including all
six of Pimco's municipal bond funds.
Pimco, a unit of Germany's Allianz, does not offer a high-yield muni fund. "I
believe it simply isn't worth the incremental risk for the extra percent or two
of yield," Mr. McCray said. "Sure, it would be much easier to advertise and
market a nice juicy yield, but I don't believe our municipal investors would be
well served."
A top official at the Vanguard Group, the nation's second-largest manager of
bond funds, disagreed. "I think that's hogwash, to say that a high-yield muni
fund has no place in a portfolio," said Ian MacKinnon, chief of Vanguard's
bond operation. Mr. MacKinnon called the Heartland revaluation "appalling"
but said it should not sully high-yield muni bond funds as a category.
In fact, Vanguard's high-yield muni fund bears little resemblance to
Heartland's. The Vanguard High-Yield Tax Exempt fund is not even
considered a high-yield fund by Lipper Inc., the fund tracker The fund itself
has only 10 percent of its $3 billion in assets invested in unrated debt.
By contrast, Heartland High-Yield Municipal, as of midyear, was nearly 97
percent invested in unrated debt. Such bonds, traded infrequently, are the
most difficult to value. "A more normal allocation to nonrated debt would be
50 percent," said Christopher J. Kelsch, a Morningstar analyst. "They were
way out there in terms of risk."
Most larger firms estimate the value of such bonds by using pricing services
and their own analysts. It is part art and part science.
Until October, Heartland relied largely on a pricing service. Both Mr.
MacKinnon of Vanguard and a Merrill Lynch executive questioned whether
Heartland could effectively check its pricing service's work. "Obviously, they
didn't have people out there in the field doing what we do," said Hugh T.
Hurley III, a vice president in Merrill Lynch's bond department. "It was
negligence, either by accident or on purpose."
Doug Lucas, a Heartland spokesman, said the firm is best known for stock
funds. "It is important to keep in mind that we have more than 98 percent of
the assets of this firm in the equity side," he said. Bond funds, he said, are
"relatively new assets."
In 1997 and 1998, the Heartland High-Yield Municipal fund was a top
performer, but now investors wonder if the fund's past net asset values were
a mirage. "People who bought these funds feel like they've had their pockets
picked," said Samuel H. Rudman of Milberg Weiss Bershad Hynes & Lerach,
a New York firm representing the plaintiffs in one of the suits.
William J. Nasgovitz, Heartland's president and founder, said the risks were
clearly described in prospectuses. He placed much of the blame for the two
funds' troubles on the markets, saying that buyers for illiquid high-yield
munis like those in the Heartland funds had grown scarce. "We changed the
pricing to match the reality of the marketplace during the week of Oct. 9," he
said, citing the Owens Corning bankruptcy filing and a general falloff in
high-yield trading.
Heartland itself has revised its method of valuing these bonds to reflect, Mr.
Nasgovitz said, "credit quality concerns, lack of market makers, lack of bids"
and trading in similar bonds.
Mr. McCray of Pimco said investors might want to be cautious about any
high- yield muni bond fund. "As the economy slows, lesser credits will
suffer," he said. "Investors in high-yield munis may find that the incremental
1 percent or 2 percent of yield doesn't pay for the risks."
Mr. Zaslaw had expected the $3,000 investment to pay a regular income
without substantial risk. "Certainly I expected the principal to be preserved,"
he said.
So would just about any other investor who bought a bond fund. Now such
conservative investors might want to think twice.
"Investors should rightly consider their investments in high-yield municipal
bond funds as risk capital," Mr. McCray said. That does not mean one should
expect to end up with a fund that drops 70 percent in a day. Unless it's
Friday the 13th
Copyright 2000 The New York Times Company |
