BUSINESSWEEK ONLINE : DECEMBER 11, 2000 ISSUE
BUSINESSWEEK INVESTOR Lessons from a Muni-Fund Nosedive The sad tale of Heartland yields warning signs for investors As bond market blowups go, the collapse of Heartland Advisors' two municipal-bond funds was small-time. The fall was painful for shareholders--write-downs in the funds cost them $64.9 million in one nasty afternoon. But compared to Long-Term Capital Management, whose 1998 losses threatened to topple many Wall Street firms, the bond market got off easy because the Milwaukee-based funds had less than $120 million in assets. Still, Heartland offers valuable lessons. There were warning signs that attentive investors might have spotted. And Heartland management made bad decisions that regulators did not recognize soon enough. Here's what happened. On Oct. 13, Heartland Advisors, faced with portfolios of low-quality, illiquid municipal bonds, marked down the values of Heartland High-Yield Municipal Bond Fund and Heartland Short Duration High-Yield Municipal Fund by 69.4% and 44%, respectively. Those kind of one-day losses are unheard of--even in a high-risk equity mutual fund. Heartland said it repriced bonds in the portfolios because of the ''current lack of liquidity'' in the high-yield muni market and ''credit quality concerns.'' Lawsuits followed soon after, arguing that the portfolios had been mispriced all along. Since the two funds' bonds were illiquid, gauging price accuracy was difficult. Heartland had relied on an outside pricing service, but eventually the firm applied a ''fair value'' system to estimate the bonds' worth. That's when the markdowns occurred. There are lessons to learn from this fiasco: -- Learn how to read the prospectus and shareholder reports. Indeed, the fine print of these documents contained signs of danger ahead. Just look at the Heartland High-Yield Municipal's June 30 semiannual report. That report, not filed until Aug. 21, showed that the fund used a line of credit. During the first six months of 2000, the loan, made by Deutsche Bank, had an average daily balance of $10.3 million. That was 14.5% of the fund's $70.8 million in assets on June 30. At the same time, Heartland Short Duration High-Yield Municipal reported an average daily loan balance of $13.3 million, or 13.2% of assets. True, the prospectus showed the funds could borrow up to a third of total assets ''to avoid liquidating securities under circumstances which Heartland Advisors believes are unfavorable to shareholders, such as to meet large or unexpected redemptions.'' That in itself wouldn't raise red flags, since most funds have credit lines. But it's rare for funds to use them. ''In my experience I haven't seen anybody using their credit line,'' says a Big Five accountant with 25 years' experience auditing mutual funds. The idea of the credit line is to allow a fund to make redemptions while waiting for the proceeds of its securities sales to arrive--bridging a few days' liquidity gap. With Heartland, the loans went on for months. Apparently, ex-portfolio manager Tom Conlin--the company announced his resignation Sept. 28--was borrowing money to pay off shareholders who wanted to redeem. The loans allowed Conlin to avoid selling bonds and realizing large losses. Conlin declined comment. Perhaps he thought the bonds' prices would recover--but they didn't. The impact of this decision was to perpetuate the funds' inflated net asset values (NAVs). That meant shareholders who redeemed over the summer were paid more than their shares were worth. The money came from loans that had to be paid back with what could be salvaged from the portfolio. Heartland spokesman Doug Lucas says management did what the prospectus allowed. During this time, Heartland used Interactive Data, an independent pricing service, to value its bonds. Art Brasch, Interactive's director of municipal services, says its prices are only good for ''normal market conditions,'' not the distressed sales that Heartland was facing. -- Be wary of the highest-yielding fund. Before its fall, Heartland High-Yield Municipal sported the highest 12-month yield of any muni fund, 7.3%. Since you don't get higher yields without taking greater risk, this huge payout should have prompted investors to take a closer look. Heartland earned extra yield by taking credit risk: buying bonds either rated below-investment grade by the ratings agencies, or bonds that had not been rated at all. Nonrated bonds aren't necessarily bad credits; they can come from issuers too small to pay for a rating. Most high-yield muni funds invest in nonrated bonds, but none came close to Heartland. The June report for Heartland High-Yield revealed that 96.7% of its portfolio was nonrated. In comparison, only 13 of 248 national muni-bond funds had more than 50% of their assets in nonrated bonds, according to Morningstar. Bond-fund managers run their own credit reviews. In the June 30 report, Heartland's analysis shows 88.6% of its nonrated bonds were below investment grade. More telling, 8.4% of the bonds were in default. Even when nonrated bonds make their payments, they can be problematic. Few buyers will take them on without a lot of credit research. And if funds need to unload them quickly, there may be no takers. -- Stick with the large muni-bond managers. High-yield or ''junk'' bonds require the most rigorous credit analysis. Heartland, a boutique firm, had only two muni analysts. Major muni managers like Franklin and Van Kampen, with large research staffs, have fared better in this tricky market. Moreover, a larger fund will usually have enough cash inflows to make redemptions without dumping bonds. What's more, the steady income provided by a larger portfolio should enable it to meet redemptions more easily. -- Don't count on regulators' help. According to the Securities & Exchange Commission, mutual funds shouldn't have more than 15% of their assets in highly illiquid securities. Heartland's portfolio must have been way over that line, but the SEC did nothing about it. In part, fund lawyers say it's not clear how to define an illiquid security. Heartland's Lucas says through this entire period, the portfolios were in compliance with the 15% rule. If so, then why did the funds have to tap their credit lines? One reason regulators are behind the curve is poor fund disclosure. Mutual-fund activists have been lobbying the SEC for years to require funds to make better and more frequent reports of their holdings. Right now, funds have to give a complete account of themselves only twice a year. John Rekenthaler, Morningstar's research director, argues that if funds were made to put out quarterly reports at the same time, fund watchers would be able to spot problems more easily. Now, funds make their own timetables. With better disclosure, shareholders could get out of troublesome funds before they blow up. Better yet, putting a brighter light on the inner workings of the funds might prevent the next Heartland fiasco from happening. BY LEWIS BRAHAM _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS Lessons from a Muni-Fund Nosedive CHART: Hard Times in the Heartland INTERACT E-Mail to Business Week Online

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