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Muni Bonds for the Long Haul

Unlike many bond investors who focus on short-term changes in interest rates, Phil Condon, manager of Scudder Managed Municipal Bond fund (SCMBX), stresses the long run to build stable returns. He particularly favors 15-year to 20-year munis, because longer-term bonds haven't performed as well (and therefore have higher yields) vs. shorter-term issues.

In general, changes in interest rates may affect the net asset value of funds focusing on long-term bonds more than short- or intermediate-term funds. To reduce risk, Condon stresses high-grade muni bonds, giving the $5 billion fund a 65% to 70% allocation in AAA-rated and insured bonds. He doesn't think lower-quality muni bonds offer much better returns than high-grade munis.

Condon's strategy appears to have worked well during the recent rally in the muni-bond market and over longer time periods. This year through August, the fund rose 8.2%, while the average long-term municipal (national) bond fund was up 6.5%. For the 10-year period through last year, the fund gained an annualized 6.4%, while its peers rose 5.8%. Based on risk and return characteristics over the past three years, Standard & Poor's has assigned Scudder Managed Municipal Bond an overall rank of 4 STARS (5 is the highest, 1 is the lowest).

Bill Gerdes of Standard & Poor's Fund Advisor recently spoke with Condon about his fund's investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:

Q: What are the fund's main objectives?

A: It's a high-grade fund that focuses on income over the long run. There are trade-offs. You can maximize your income in the short run, but you'll probably take on inappropriate

call risk,

credit risk, or maturity risk. An investor who picks the highest-yielding fund will likely end up with underperformance because of the additional risk.

Q: So your primary goal is income over the long run?

A: Yes, it is. Most of our investors realize that if I have good call protection on my securities, the income won't disappear when the bond market rallies, as it has lately. A callable bond may not appreciate as much as a

noncallable bond.

Q: Do you avoid callable bonds?

A: We use a fair amount of noncallable bonds, but we'll also use

premium-coupon bonds that are trading to an attractive call. If rates go up or down by 10 to 20 basis points, that bond's

duration won't have a dramatic change.

Q: What's the fund's duration?

A: I aim for a duration-neutral portfolio, because I'm not very good at predicting where interest rates will go, and I don't know anyone who is. Instead of making big bets on interest rates, we make a lot of smaller bets on the

yield curve, credits, the right coupon, and the call feature.

Q: What is your view of the yield curve?

A: The curve is now about as steep as it usually gets, particularly in the 10- to 20-year part of the curve. Typically, we like the 15-year part of the curve, but we're starting to move into the longer end of the 10- to 20-year part of the curve because it's more attractive than the shorter end on a duration-neutral basis.

We've been underweighted in 20-year bonds, but now that that area has underperformed, we're trying to get more investments there. As the curve shifts back a bit, we'll make changes in the portfolio.

Q: Why's the yield curve so steep in the muni-bond market?

A: There's a mismatch of supply and demand. The typical muni bond has 20 to 30 years to maturity, while most muni-bond investors look for intermediate to short-end bonds. Therefore, the market has to pay a higher yield to entice investors out on the yield curve.

Q: What is the fund's credit quality, and does it change very often?

A: Our credit quality has been pretty consistent. The fund is 65% to 70% in AAA-rated and insured bonds, and about 10% in BB and nonrated bonds. In the muni market, when you go from AAA to AA to A, there isn't a large pickup in yield -- about 10 to 15 basis points between AAA and AA.

Q: Several states have had budgetary difficulties because of the weak economy. How has that affected the municipal market?

A: With a few exceptions, municipalities usually have political problems rather than economic problems. Most states have rainy-day funds, and as long as states are responsible, credit quality generally doesn't suffer. States usually pass the buck by cutting payments to counties and towns, which then have to cut their expenses.

Q: What states are you currently overweighting?

A: We typically have a higher exposure to Illinois and Texas. Those states tend to have higher-than-average yields because they don't give tax exemptions to their residents. We will go back and forth with certain states on a monthly basis, depending on supply and demand, although we do very little short-term trading.

Q: What's the fund's turnover?

A: It's in the 30% range. I'm very conscious about minimizing taxable gains for our clients. Embedded gains aren't a problem for muni bond funds as long as the manager avoids taxable events.

Q: What accounts for the fund's strong long-term track record?

A: The consistency of our style. I'm always happy when my competitors have strong opinions about the market, because invariably they get hurt when the market reverses itself. While income is important in the short run, it's more important over the long run.

Q: What type of investor is best suited for your fund?

A: Most of our shareholders are looking for a balanced portfolio. Many people who didn't have this type of fund in their portfolio two years ago now realize the advantages of muni-bond funds.

Q: With the recent rally in the muni market, is there still upside potential for a new investor?

A: I don't know what rates will do, but muni-bond rates are very attractive vs. inflation. You can buy a 20-year muni bond at about 5%, and inflation is between 1% and 2%. Muni bonds are also attractive because of the supply/demand ratio and heavy issuance this year.

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