Friday, October 13, 2000 proved to be an unlucky day for shareholders of the Heartland High-Yield Municipal Bond Fund and the Heartland Short Duration High-Yield Municipal Fund. In a single day the net asset values of these two funds declined 70% and 44%, respectively due to a pricing adjustment. And you thought technology funds were volatile.
This was the second pricing adjustment that these funds experienced in a two-week period. In late September, Heartland marked down the net asset values (NAVs) of the High-Yield Bond Fund and the Short Duration High-Yield Municipal Fund by 8.2% and 2.1%, respectively, when some of the defaulted issues in the funds’ portfolios were repriced. Single-day devaluations of this magnitude are unheard of, especially for municipal bond funds.
In the fund’s prospectus, Heartland describes the Short Duration High-Yield Municipal Fund as a fund that “seeks a high level of federally tax-exempt income with a low degree of share price fluctuation.” In its annual report, Heartland presents the short duration high-yield fund as being on the low-end of a risk/return spectrum, one notch riskier than a money market fund. High-yield bond funds have above average credit risk, and for assuming this additional risk investors are rewarded with additional yield.
Both of Heartland’s high-yield funds primarily consist of illiquid, unrated municipal bonds, which may not trade for weeks or months at a time. According to Morningstar, over 96% of the High-Yield Municipal Bond Fund’s assets and more than 82% of the Short Duration Municipal Fund’s assets were invested in non-rated issues as of June 30, 2000.
Tom Conlin had managed both funds since their inception in January 1997. He resigned last August, although Heartland did not make his resignation public until September 28, the same day the initial devaluation occurred.
Good, Bad and Ugly
Earlier this year Morningstar, the mutual fund research firm, assigned Heartland’s two high-yield muni funds five-star ratings, which meant that the funds landed in the top ten percent of the municipal bond asset class in terms of risk-adjusted returns. As of September 30, 2000, the High-Yield Muni Bond Fund and the Short Duration High-Yield Muni Fund’s one-year annualized returns were —13.51% and —2.97%, respectively, after taking into account the initial devaluations. As of October 13, the funds’ year-to-date total returns were —72.75% and —46.57%, respectively. During that period the High-Yield Muni Bond’s assets decreased from $78 million to $18 million and the Short Duration High-Yield Fund’s assets declined from $122 million to $39 million.
Heartland attributes the sharp decline in the funds’ net asset values to a change in the fund company’s pricing structure and not to a one-day decline in the value of the funds’ underlying holdings. Prior to October 13th, Heartland had been receiving its bond prices from Interactive Data (IDC), an independent pricing service. However, Heartland’s pricing committee had the authority to override these prices if it didn’t agree with IDC’s valuations. Thus, the methods used to calculate bond prices in the two funds remain a mystery, since neither company has commented on previous pricing practices. What we do know is that Heartland was carrying outdated values for some of the bonds in its high-yield muni bond funds.
In late October, the Wall Street Journal hired J.J. Kenny, another independent pricing service, to review the High-Yield Municipal Bond Fund’s holdings as of June 30, 2000. J.J. Kenny noted that the fund was valuing some bonds at prices 60% to 115% higher than the values it provided to other fund companies holding the same bonds.
After the September 28 devaluations, Heartland began to liquidate some of its holdings to meet fund redemptions. The funds were selling their illiquid bonds into an unsympathetic municipal bond market, forcing the funds to accept low prices. According to Heartland, this “fire-sale” approach led the fund company to shift to a “fair-value” pricing method because Interactive Data’s prices did not accurately reflect the market value of the bonds. Fair-value pricing is an estimate of a holding’s value based on various factors, such as market conditions, liquidity, as well as prices provided by an independent service. The SEC considers fair-value pricing to be more appropriate for securities in which market prices are not readily available.
Heartland submitted a prospectus supplement to the SEC for the High-Yield Municipal Bond Fund and the Short Duration High-Yield Fund dated October 16, 2000. The supplement stated that due to a general lack of liquidity in the high-yield municipal bond market, these funds would now use fair value pricing to determine the value of the underlying securities and to calculate the funds’ NAVs. Several municipal bond fund managers disagreed with Heartland’s take on the high-yield muni bond market. The SEC has closed the Heartland’s high-yield muni funds to new investors indefinitely while they investigate.
If you choose to invest in mutual funds composed primarily of thinly-traded securities, you should monitor these funds closely.
- First and foremost, contact the fund company to verify the pricing method used to value the fund’s underlying holdings.
- Read the fund’s prospectus, quarterly report, semi-annual report and annual report very closely. Investigate any material changes to the fund’s investment strategy, to fund management, or to the type of securities it holds.
- If possible, compare your fund to other mutual funds of similar composition.
- Consider the proportion of holdings that have defaulted or have been de-listed over the last few years.
- Avoid an illiquid fund with a small asset base because a few security write-downs can have a major effect on the fund’s net asset value.
In order to avoid becoming the victim of a fund devaluation, beware of the following warning signs:
- The fund you are considering currently yields much more than any other fund in its category. This is usually a sign that the fund contains very risky investments. Heartland’s Short Duration High-Yield Municipal Fund’s yield, for example, was 6.5% on April 28, 2000, while similar funds were yielding 5.5% on the same date.
- The fund’s composition has an irregularity. For instance, in early 1999, Palisades Hudson Asset Management, Inc. purchased shares of both Heartland high-yield municipal bond funds for some of its clients. Last February, we discovered that the Heartland Short Duration High-Yield Municipal Fund was carrying a negative cash position, which implied that the fund was leveraging its portfolio. When we contacted Heartland, they informed us that the portfolio might maintain this negative cash balance indefinitely. Typically, investors use a short duration bond fund as a short-term parking place for idle cash to reduce exposure to interest rate risk. Thus, leveraging a short duration bond portfolio seems inappropriate since many investors could decide to redeem their shares today or tomorrow. Exposing cash for short-term needs to additional risk led us to liquidate our clients’ positions in both funds immediately.
Although the business section of your daily newspaper may report the NAV of a fund with illiquid securities, you should not assume that it holds the same validity as the NAV of a fund that invests in securities that trade frequently. Remember that the NAV of such a fund is based merely on fund management’s opinion of the value of its holdings. What matters most is the quality of the estimate and the fund company providing it.