That past includes a difficult 2007, when the fund posted a 3.13% return, compared to 1.15% for the Lipper General Municipal Debt Fund average. A key factor in boosting relative performance was to underweight discount bonds in favor of overweighting intermediate-maturity premium bonds trading above par value. Premium bonds significantly outpaced discount bonds because as bond yields rose, many discounts fell in value as they approached or reached price levels where they became subject to unfavorable tax treatment. Bonds priced above par also benefited because their intermediate maturities made them sensitive to interest rates, which fell during the final months of the year.
While Thompson keeps the fund's duration in line with the Lehman Brothers index to avoid making interest rate bets, she will make adjustments to credit composition or bond structures. A decision to modestly overweight lower-quality investment-grade municipals relative to the fund's benchmark, the Lehman Brother 3 Plus Year Municipal Bond Index, worked for much of the year. But it proved less attractive in the second half as questions about the soundness of municipal bond insurers prodded investors into higher-quality alternatives.
Widening yield spreads between the highest-rated municipals and those somewhat lower on the credit rating ladder are prompting her to look for bargains in bonds of issuers a bit further down the ratings scale. From 2003 to August 2007 risk premiums were fairly tight and investors were not being paid to invest in less than stellar issuers, she says. But since August risk premiums have expanded aggressively as risk-wary investors flock to safety. "A year ago a triple-B hospital bond was trading at a tight spread of just 40 basis points off of a triple-A rated bond. Now, the spread is about 140 basis points. That's a pretty aggressive risk premium expansion in such a short period of time."
At the end of January, the fund had about 68% of assets in triple-A rated securities. Thompson anticipates reducing that exposure over the next couple years as buying opportunities arise to shift some of the money into higher-yielding mid- and lower-tier credits.
She continues to favor bonds selling at a premium over par value, particularly those that are likely candidates for an advance refunding. In an advance refunding, the issuer sells new bonds prior to the first call date in order to repay more expensive outstanding bonds with higher coupons. The proceeds of the new issue are typically invested in government securities placed in escrow. Once an issuer announces an advance refunding, the price of the outstanding bonds will typically jump to reflect the shortened life of the now-secured debt. Thompson says it is not unusual for a bond to gain 5% or more in value on the set up of an escrow account. At times, she will also buy bonds at a slight discount to par value, but avoids those with deeper discounts because of potentially unfavorable tax consequences.
Insured municipal bonds tarnished by insurer credit rating issues are also on her radar screen. Default rates on municipal bonds are very low, so in many cases the insurance is more window dressing for retail investors than anything else. "Insured bonds represent some of the better values around today because even the ones with solid credits behind them have been punished by the market. The key is doing a thorough analysis of each issuer and each bond," she says.
