Why is my tax-exempt fund dropping in value?
QUESTION: Why is my tax-exempt bond fund dropping in value?
ANSWER: You've just been introduced to one of the drawbacks of investing in a bond fund instead of an individual bond. If you held a specific municipal bond until maturity, you would have a fixed rate of income, and you wouldn't need to worry about the underlying value of the bond on the secondary market unless you wanted to sell it. On the other hand, bonds held in funds are priced daily and reflect current market conditions. A bond fund "is not a fixed-income security," explains Ramy Shaalan, senior fund analyst with Wiesenberger Thomson Financial. And these days, this means some funds have edged off their highs.
Of course, while the bond market has softened after a strong performance in 2000, bond funds are still doing better than most equity funds. Year-to-date, the average intermediate national municipal-bond fund was still ahead 1.66% through April 10, according to Morningstar. So if you're in the 36% tax bracket that's a year-to-date return of 2.59% after taxes. Small, maybe — but wouldn't tech-fund investors be happy with that right now?
Why does the value of a bond fund rise or fall? Largely because of what's happening to interest rates: Falling rates benefit bonds while rising rates hurt them. Other factors include the duration of the bonds held in the portfolio (longer maturities fluctuate more), their quality, market sentiment and the fund manager's trades. And while it's true that interest rates have been on the decline this year and further rate cuts are expected, that has largely been priced into the market. "I just don't think you can count on a very high total return this year — nothing like last year. But it's still a very good place to be given the volatility in the stock market," says Eaton Vance's Bob MacIntosh, who manages 12 municipal-bond portfolios with assets totaling $1 billion.
Even if these funds don't repeat the gains of last year — when the average intermediate national muni fund racked up an 8.8% return — they could still be attractive, as MacIntosh suggests. Don't forget, your muni-bond fund has two elements to its gains or losses: yield and total return. A bond fund's yield is simply the average yield, or rate of interest payments, of the bonds the fund holds. And these days the average municipal-bond fund yields 4.4%, according to Morningstar. Total return, on the other hand, takes into account both the regular annual payments of the bonds the fund holds as well as any change in the bonds' underlying value. These days, bond prices are holding fairly steady, meaning these funds' returns are largely coming from their yield, MacIntosh says.
Over three or five years, many muni-bond funds' returns are still healthy even after factoring in some down years like 1999. But if you find you really can't stomach fluctuations in your bond fund, Scott Berry, a bond analyst with Morningstar, recommends owning individual bonds. "You'll know exactly how much you're going to get when the bond matures even though the value may fluctuate," Berry says. Unfortunately, creating a moderately diversified portfolio of individual bonds can be quite expensive — as much as $100,000 to start — which makes bond funds a better option for many investors. Selecting individual bonds also places the burden on you to monitor the credit quality of your holdings, although defaults remain highly uncommon, affecting just 0.47% of muni bonds on average in the 1990s, according to Standard & Poor's J.J. Kenny. (For more on this, see our story "Bonds vs. Bond Funds.")
One caveat, however: If you're seeing dramatic changes in your fund's value, investigate further, advises Roy Diliberto, a Philadelphia-based financial planner with RTD Financial Advisors. "I would try to find out why that's happening," he says. Sometimes, what's behind your fund's change in value might be as simple as a shift in duration. A darker alternative is a credit blowup. Granted, that's a rare occurrence, but it can happen, as was shown last fall when two Heartland high-yield municipal-bond funds repriced illiquid, largely nonrated securities and declined in value by more than 40%. That's a dire and unusual situation — but as always, you need to be on top of your investments.