Some tax-free bond funds have been taking on a lot more risk. And many tax-free fund shareholders are not aware of these extra risks until their shares fall. Here’s what’s happening.
Several years ago, some smart people realized that if they could sell short-term tax-free securities to the public at a low rate, they could take this money and invest in higher-rate long-term municipal securities. As an executive from the industry explains:
"We can invest proceeds of the offering in high-quality long-term municipal bonds that, as of Nov. 19, 2001 , are yielding nearly 5%. That's a spread of about 325 basis points above current yields on benchmarks like the 30-day Treasury bill. This additional income could certainly enhance yield on common shares of these funds."
What he does not explain is that this advantage can become a disadvantage. When short-term rates rise above long-term rates, which they periodically do, the fund will be paying more on the borrowed money than they are earning. This results in losses for fund shareholders. The leverage increases the fund’s fluctuation.
Many people invest in tax-free bond funds because they feel these funds are conservative investments. But you may not want the kind of volatility you see above.
So ask if your municipal fund has been borrowing or selling preferred shares against the bond portfolio (this information is always in the prospectus). If so, you'll want to decide if the sizes of the gains or losses that are magnified with leverage are comfortable for you. And remember, even if you have an “insured” tax-free fund, that only means that the bonds in the fund are insured and your shares are not insured against loss. To find out what’s in your bond fund, return the enclosed coupon for more details.