Yet Another Reason to Avoid Municipal Bond Mutual Funds

One investment category I have always thought was a blight on the retail investment world was the Municipal Bond mutual fund. There is no worse way to invest in the muni bond segment than this one, and it should be manifestly self evident to even a casual observer, but, there are juicy loads to be had for those selling them, oftentimes trailing fees as well, and the fund managers reward themselves handsomely. So handsomely, I am torn between either kicking myself for not engaging in this legalized highway robbery, or having some pride in being one of the few advisors who devotes so much time and effort to participate in the space. This is chiefly due to my New York location and the need to serve my client base, who stand to benefit the most in a high tax state that happens to have the most robust market in all of municipal finance. But the funds are an easy sell and they get pushed to a willing public. After all, they reason, everyone knows municipal bonds are safe as brick houses and there's that tax advantage too. Who wants to pay more taxes, even if the returns themselves are less than optimal, right?

Well, aside from the front loads, the trailing fees, cash that can't be put to work since some must be held to the side for inevitable redemptions, the cost and overhead of maintaining a fund with highly paid managers, SEC filings, compliance costs, and the routine stuffing of “conservatively managed” funds with sub prime paper to spike the yields, we've just found yet another reason to not even look at the things anymore.

Since I avoid muni mutual funds, I rarely revisit them as I do other investments which may be poised for a rebound or worth a fresh look to see how they're trending. But the recent fiscal problems in the Commonwealth of Puerto Rico kind of forced me to take notice of them again. The small army of municipal finance professionals I'm in touch with brought up a particularly distressing matter regarding some state specific muni bond funds from a certain issuer. These funds are designed to avoid the tax issue of a muni bond purchased out of the issuer's state. When I first investigated this, I thought I could forgive the fund managers use of Puerto Rico bonds since smaller states, like Maryland or Virginia, don't exactly offer a full course of offerings. They're just not major players in the space like New York or California, so they needed the fully tax free component of the Commonwealth's bonds. Then further investigation came up with this:

State % state bonds % Puerto Rico

Virginia 53.2% 46.2%

Arizona 75.0% 30.0%

Maryland 45.3% 49.7%

Ohio 87.8% 15.2%

N. Carolina 69.4% 35.3%

New York 77.1% 26.6%

(Some figures are over 100% due to the use of leverage)

There are several take aways from this. One, you can bet most holders of these funds in Virginia or Maryland have no idea there are a few sticks of dynamite in these portfolios. Two, my objection isn't so much that the funds own bonds issued by the Commonwealth, but that their specific asset choices were reckless, and not the least bit prudent. Third, despite the cynical use of this paper, ostensibly to spike the yields of these funds, returns are sub-optimal compared to even the most underperforming muni ETF, or if that's too volatile for you, a decent, laddered portfolio could be constructed.

But there's a good reason these managers have to stuff these portfolios with genuine junk: to overcome a larded up fee structure. The gross expense ratio on some of these products exceeds 2%. The front load can range from 1% to 4.25%. And the coupon income can't get past 5% even for the most aggressive of them. Most galling is the realization that the managers barely do any work: portfolio turnover is usually well under 20% or in some cases I found, completely non-existent.

Which brings us to the key point: The mutual fund construct is utterly useless for this segment of investing. Meaning that if you're a person of such means that your tax liability is so onerous, so that a considerable portion of your assets must be sheltered in this manner, why not just get individual bonds and keep all of the yield for yourself?

With your own portfolio, at least you can structure maturity dates for the liquidity you need, when you need it. If you're in a bond fund, you're on a perpetual escalator that never stops, and the day you need to step off may not be the most profitable one. Bond funds have no maturity date.

In Maryland's and Virginia's case, with the top marginal tax rate at a relatively paltry 5.75%, that alone would be a compelling reason to simply avoid going through all of this trouble just to keep a small portion of your portfolio completely tax free. You could buy a municipal bond of genuine worth from any state in the union, and if it's from New York or California, you'll get more liquidity and better pricing if you ever have to sell it. Unless you're one of those people who gets some sadistic satisfaction out of avoiding paying tax at any cost, it's just not worth it.

Lastly, why the ostensibly experienced and “seasoned” Chartered Financial Analysts who manage these funds thought that there wasn't enough of a choice of issuance for a state specific New York State fund is beyond my ability to comprehend.