The Appeal of Taxable Muni Bonds

Lebenthal's specialist fund is outperforming all its muni-bond competiors. Manager Gregory Serbe explains why

Many fixed-income investors might be surprised to learn that there are municipal bonds that are subject to income taxes. They might be downright astonished to learn a fund specializing in taxable munis has outperformed all muni-bond funds this year. But that's what the $14.7-million Lebenthal Taxable Municipal Bond Fund -- the only one of its kind -- has done.

Year-to-date through Sept. 30, the portfolio gained 14.6%, making it the best performer among muni-bond funds for the period. The average muni bond gained 8.7%. The Lebenthal fund also made a stellar showing on both an absolute and risk-adjusted basis for the three years ended in September, with an average annualized return of 12.4%. By comparison, the average national long-term muni-bond fund returned 7.2% for the same three-year period.

Since April, 2001, Gregory Serbe has been lead manager of the fund, which started in December, 1993. He served as assistant portfolio manager from 1998 to 2001. The fund has carried Standard & Poor's highest overall ranking of 5-STARS since September, 2001. Palash Ghosh and Daniela Valle of Standard & Poor's Fund Advisor recently spoke with Serbe about the features of taxable munis and the fund's investing strategy. Edited excerpts from their conversation follow:

Q: What exactly are taxable municipal bonds?

A:

Taxable munis arose from various federal tax-law changes starting in the early 1980s. The federal government decided it would regulate the muni-bond market as well as limit the types of tax-free municipal bonds that could be issued.... The federal government will not subsidize the financing of certain activities, such as investor-led housing and industrial projects, local sports facilities, or the funding of a municipality's underfunded pension obligations.... Probably their greatest advantage is the issuer's ability to earn and keep arbitrage profits that are connected with a taxable issue. This makes taxable bonds very attractive for funding pension-fund liabilities.

Q: What is the size of the market?

A:

It has grown phenomenally in recent years -- about $75 billion in taxable municipals has been issued in the past five years. Along with increased investor interest have come an increase in liquidity and a tightening of spreads.

Q: How do you run this portfolio?

A:

From an overall strategic view, we manage for total return. We're not only looking at the juiciest yields, we place a premium on high credit quality and liquidity. We also look at the shape of the yield curve to find the best values.

Q: Is your fund the only open-ended taxable municipal-bond fund?

A:

As far as we know, we are the only one. We're typically classified as a corporate-bond fund because the interest income from taxable municipal bonds is taxable on a federal level. However, there are certain states that exempt some of their taxable municipal bonds from state income tax.

With all other things being equal, a municipal bond with a state tax-exemption will have a slightly higher price and lower yield than a municipal bond, which is subject to both federal and state taxes.

Q: What are the fund's top sectors?

A:

As of Sept. 30, the largest sectors were general obligation, 24.7%; housing, 11.4%; airport revenue, 10%; pension, 6.9%; education, 6%; health care, 5.9%; stadium, 5.8%; federally insured hospital, 5.5%; dedicated tax, 4.8%; long-term care, 2.9%; lease back, 2.7%, and tobacco, 2.4%.

Q: What are the fund's other statistics, including current average yield?

A:

[Again] as of Sept. 30, the fund's average coupon was 7.4%; current average yield, 5.6%; average maturity, 10.9 years; and average duration, 6.8 years.

Taxable municipal bonds tend to have higher yields than tax-free municipals because, among other things, the income is federally taxable, whereas the interest income from traditional municipal bonds is federally tax-free. Because of this, taxable municipal bonds, like corporate bonds, trade on a relationship to the U.S. Treasury market.

Q: Who purchases taxable municipal bonds?

A:

The buyers of taxable municipal bonds tend to be investors in a low tax bracket, like retirees, or those looking for fixed-income investments for their retirement accounts.

Interestingly, over the past couple of years, large insurance companies that have traditionally purchased corporate bonds have started putting money into taxable municipals because they're becoming increasingly concerned with the event risk associated with corporate bonds, given the disastrous recent events with companies like Enron and WorldCom.

If a municipality gets into trouble -- unlike a corporation -- its services and infrastructure may be taken over by another entity. Obviously, a city can't disappear. When New York City got in trouble in the 1970s due to overborrowing, the State of New York formed the Municipal Assistance Corp., which prevented the city from going bankrupt.

Q: What is the fund's credit profile?

A:

As of Sept. 30, 79.45% of the fund's assets were invested in AAA-rated securities; 15.58% in AA, and the remaining 4.97% in A.

Q: What are some of the advantages of investing in taxable municipals?

A:

The advantages depend on your tax bracket and on the spread relationship between the taxable municipal bonds and tax-free municipals. Let's say you're in the maximum federal, state, and local tax bracket which, here in New York City, amounts to about 45%-50%. If you can buy a Treasury at 5%, a taxable muni at 6%, and a tax-free muni at 5% (all with similar maturities), the best buy for you would actually be the tax-free municipal. However, if this investment was for a retirement account, the taxable municipal bond would probably be more appropriate.