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A recent crisis involving a couple of small high-yield municipal bond mutual funds hammers home the eternal lesson about extreme

credit risk: It works, until it doesn't work.

Bond investors take credit risk when they buy

speculative-grade bonds -- bonds issued by financially fragile entities, making it conceivable that they will fail to pay interest and repay principal in full and on time. The enticement for taking credit risk is that these junk bonds have high yields. As long as the issuers don't default, high-yield bonds can outperform

investment-grade bonds, which don't yield as much.

The problem is that issuers sometimes do default. And when they do, not only do investors lose the payments from those bonds, they may also lose the ability to sell those bonds, even at extremely low prices. Meanwhile, the prospect of additional defaults may make it tough to find buyers for other extremely risky bonds.

In the last analysis it was extreme credit risk that did in a couple of muni mutual funds run by Milwaukee-based

Heartland Advisors

over the course of the last month. The funds --


Heartland High-Yield Municipal and


Heartland Short-Duration High-Yield Municipal -- have popped up in this column before (on

Jan. 28, 2000, and on

Oct. 22, 1998). Hopefully, you heeded the warnings and steered clear.

The Heartland funds lived on the edge. As of their latest public filings on June 30, Heartland High-Yield had 97% of its assets in

nonrated bonds and the remaining 3% in issues rated single-B or triple-C. Heartland Short-Duration was 82% in nonrated issues and 18% in issues rated triple-B or lower. Those are extreme numbers.

According to


, the average credit-quality distribution for high-yield muni funds is 44% investment-grade, 56% speculative-grade. (That's why this story should not necessarily alarm investors in other high-yield muni funds.)

The funds lacked sector diversity, too: They were heavily laden with bonds issued to finance nursing homes.

The trouble started on Sept. 28, when the company that was pricing the bonds in Heartland's portfolios --

Interactive Data

, a unit of


-- sharply marked down the prices of some of the bonds in Heartland High-Yield. Which ones, how many, by how much, and, most important, why -- isn't clear. Neither Interactive Data (which didn't return a phone call) nor Heartland is saying.

Interactive Data and

J.J. Kenny

, a unit of

Standard & Poor's

, provide an essential service to municipal bond mutual funds: Telling them how much their bonds are worth, so that the funds can calculate their share prices every day. Stock mutual funds calculate their share prices (or net asset value) using last-trade data collected from the various exchanges.

But bonds are traded over the counter, and most munis aren't traded every day. In the absence of last-trade data on which to base their calculations, muni mutual funds pay one of the pricing services to estimate the value of their bonds, based on the levels at which similar securities are changing hands. The


requires only that in the absence of last-trade data, mutual funds calculate share prices based on fair market value, defined as the price a buyer would currently pay.

It's possible that Interactive Data on that day became aware of information about the bonds in question -- information that may have been known to Heartland previously -- that caused them to value the bonds at lower levels.

The Wall Street Journal

has reported that prior to the initial devaluation, Heartland was carrying some of its bonds at prices much higher than the prices J.J. Kenny -- whose services Heartland was not using -- was providing to its clients.

In any event, the result was that the High-Yield fund's net asset value fell from $8.80 on Sept. 27 to $8.03 on Sept. 28. (On the same day, in a move Heartland said was unrelated, the firm announced the resignation of the funds' co-manager, Tom Conlin.)

That's a big drop, and it triggered redemptions. The initial drop in the number of shares outstanding was small. But over the next two weeks, investors liquidated some 700,000 shares of the High-Yield fund (which had 6.2 million to begin with) and more than a million shares of the Short-Duration High-Yield fund (which had had 9.5 million).

To meet redemptions, open-end mutual funds have to sell assets. That's a problem when your assets are of a variety for which there is limited appetite. You may be forced to sell them at prices substantially below what you think they are worth.

This is why many investors opt to buy assets that have limited appeal -- high-yield muni bonds, syndicated loans and foreign bonds, to name three -- through closed-end mutual funds, which list a finite number of shares on an exchange and trade like a stock. Investors run the risk that the market price of the shares will fall short of the fund's net asset value. Liquidity may be poor, but because shares are exchanged rather than redeemed, fund managers are never forced to sell assets.

On Oct. 13, Heartland took a step that would largely stanch the outflows. In an SEC filing, it said it had appointed a pricing committee that would value the securities in the two funds -- and in


Heartland Taxable Short-Duration Municipal -- "based on fair value pricing procedures."

"To establish net asset values, the pricing committee ordinarily relies on securities prices provided by an independent pricing service," the filing said. "However, because of a current lack of liquidity in the high-yield municipal bond markets generally, and because of credit quality concerns and a lack of market makers, market bids and representative market transactions in the specific types of securities held by the funds, the pricing committee presently is considering factors and information in addition to prices provided by the independent pricing service in order to assess the current fair value of the funds' securities."

The step resulted in a 69% drop in the share price of the High-Yield fund, to $2.45 from $8.01, and a 44% drop in the share price of the Short-Duration High-Yield Fund. The taxable fund (whose excellent performance last year was noted in Fixed-Income Forum on

Jan. 14) has held up much better. This chart shows the damage.

Source: Lipper

Again, it isn't clear which or how many bonds were marked down, by how much, or why, and Heartland isn't saying.

The moral of the story is that too much credit risk can get you in trouble. But beyond that, the episode raises a couple of key questions, neither of which Heartland has answered satisfactorily (or at all, for that matter).

First, it seems clear that under its new pricing protocol, Heartland is valuing some or all of its bonds at much lower prices than Interactive Data suggests. If any of those bonds are also held by other bond mutual funds that are priced by Interactive Data, then wide discrepancies may exist between the prices at which Heartland shareholders can redeem their interest in those bonds, and the prices at which other shareholders can redeem their interest in the same bonds.

Second, if it is possible for two entities -- Heartland and Interactive Data -- to value the same security at radically different levels, can that security be described as liquid? If not, was Heartland always in compliance with regulatory restrictions respecting liquidity? The SEC requires that no more than 15% of an open-end mutual fund's assets be illiquid. The definition of illiquid for this purpose, according to the

Investment Company Institute

, is an investment that "may not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the mutual fund has valued the investment."