Paying the price for dabbling in unrated debt

John V. Miller may post his first annual loss since taking over the $5.1 billion Nuveen High Yield Municipal Bond Fund in 2000 because he kept almost half his assets in unrated securities as prices sank.

The manager had 48 percent of the mutual fund in nonrated bonds that funded projects such as schools, hospitals and water-treatment plants as of Oct. 31, compared with 29 percent for rivals, according to data from Morningstar Inc., of Chicago. Seventy percent of the fund is in below-investment-grade bonds.

Miller's strategy backfired this year when investors fled all but the highest-rated bonds as losses on debt backed by subprime mortgages mounted. The fund, owned by Nuveen Investments Inc., of Chicago, dropped 5.1 percent, ranking 19th of 25 rivals tracked by Bloomberg. It gained an annual average of 6.5 percent during the last five years, second behind the $8 billion Oppenheimer Rochester National Municipals.

"It's a very worthwhile fund, but clearly it was taking on more risk than its rivals," Morningstar analyst Greg Carlson said.

Spreads between yields on "AAA" municipal bonds and unrated debt have widened about threefold to 2.5 percentage points this year, Miller said. The spreads reflect "psychology and fear" that have rippled through debt markets, the 40-year-old manager said.

Municipal bonds have returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, according to Merrill Lynch & Co. Inc. indexes. That is the worst performance since 1999, when state and local government debt lost 6.34 percent of their value.

Delinquencies on mortgages to the riskiest borrowers, known as subprime loans, reached a 20-year high in the third quarter, according to the Mortgage Bankers Association in Washington. Those loans, repackaged and combined with other fixed-income securities, infected investments that prompted banks such as Citigroup Inc. and UBS AG to write down about $80 billion in losses.

Besides nonrated municipal debt, Miller's fund holds mostly below-investment-grade, or junk, municipal bonds rated less than "BBB-" by Standard & Poor's and under "Baa3" by Moody's Investors Service. Eleven percent is in investment-grade-quality securities, compared with 25 percent for the average high-yield muni fund, according to Morningstar.

"We're not in the business of repositioning between high grade and high yield," Miller said in an interview.

Morningstar gives the fund four stars out of a possible five. Its three-year Sharpe ratio is 0.09, compared with minus 0.04 for the peer group. A higher Sharpe ratio means better risk-adjusted returns.

Miller, a graduate of Duke University in Durham, N.C., with a master's degree in business from the University of Chicago, joined Nuveen in 1996 as a credit analyst. He also helps manage Nuveen's Preferred Securities Fund for private clients and the California High Yield Municipal Bond Fund.

Nuveen, which was taken private this year by Madison Dearborn Partners L.L.C., also of Chicago, has $170 billion in assets under management. The company runs five other municipal bond funds, all of which are designed to carry less risk than the high-yield fund.

Nuveen High Yield's largest holdings include a "Baa1" bond for the Baptist Medical Center in Birmingham, Ala., a nonrated issue funding a monorail construction in Las Vegas, and a "CCC+"/"Caa1" bond sold by carmaker Ford Motor Co. through the Ohio Environmental Facilities Authority.

Large issuers and those with long credit histories usually secure higher ratings. Smaller issuers, especially for bonds funded by specific, or limited, revenue sources, sometimes forgo the ratings process to save money and time. The approach was particularly popular during the credit boom that ran through last year, when many issuers decided they could secure a low enough interest rate on a bond without getting rated.

As the fund's returns sank, Miller sold some of the highest-rated assets and pre-funded bonds, both of which were in demand, to cover redemptions. The manager, who declined to disclose the amount of investor withdrawals this year, has purchased holdings in "BBB" bonds, one step above junk.

"We've been net sellers recently, but we're buying some securities where we think spreads are very attractive," Miller said, without revealing the investments.

Miller said credit markets ought to rebound next year. Supply is beginning to slacken, which will help push up prices, he said. Also, the flight from debt will slow, and investors will once again distinguish between good- and poor-quality issuers, he said.

"There's a huge premium on liquidity right now," Miller said. "I can't predict what the bottom is in price, but I think 2008 is going to be a significantly better year."

Manager:

John V. Miller.

Assets:

$5.1 billion.

Performance:

Down 5.1 percent in 2007.

Key holdings:

Baptist Medical Center, Birmingham, Ala., bonds; Ohio Environmental Facilities Authority bonds.

Ticker:

NHMAX.

SOURCE: Bloomberg News