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Lee Munson and Charles R. Major provide independent fund research on Oppenheimer Rochester National Muni A (ORNAX ).
During the 2008 crash, Oppenheimer Rochester National Muni A (ORNAX ) lost over 50% of its worth. It was one of the very worst performers. Before that it had been one of the best. Investors were clearly not expecting that type of drawdown that fast. In an article our firm wrote near the end of 2008, we discussed the oft-misunderstood tobacco revenue bonds, which made up a substantial portion of ORNAX’s bond purchases. The uncertainty of these bonds, coupled with investors’ general misunderstanding of them, led them to be mispriced and under-appreciated. These bonds are still mispriced and under-appreciated today. And they still make up the largest of ORNAX’s holdings, at around 22%. However, when we recently looked under ORNAX’s hood, we found something more interesting. Management has decided on a philosophy that could lead them to enter the property management business, a move that should concern any investor.
First: some things never change. The crowd continues to be wrong. In 2008, ORNAX lost because the credit markets were imperiled and its holdings were relatively illiquid. Poor pricing led to an investor outflow causing more selling of illiquid bonds. This has a similar effect as a run on a bank, exacerbating the impact of the market. At the bottom, investors began to chase yield and value, which ORNAX had in abundance after the fall. Then the opposite problem occurred: there were not enough good, high-yield municipal bonds to go around. When this happens, the fund has to buy new bonds at higher prices along side the investor inflow and thus reducing the yield for all investors.
So what has changed? Ron Fielding until just over a year ago managed ORNAX. Fielding’s single-minded purpose for the fund was to buy the highest yielding municipal bonds anywhere. At the time he left, the management continued to follow Fielding’s idea and model. Through all the funds past volatility, it was always guided by Ron Fielding’s vision. However, the current managers have decided that things may change. During a conference call on June 8 Troy Willis and Scott Cottier revealed that the fund is no longer simply looking to buy the highest yielding municipal paper, but that it has broken away from Fielding’s idea to begin a new life in property management.
This trailblazing move is a response to the large number of dirt bonds that are being defaulted on, primarily in Florida. Of ORNAX’s roughly 21% exposure to dirt bonds, 10-13% are Florida dirt bonds that have defaulted. But not to worry—the fund’s managers see this as a great opportunity. They figure that these bonds were for the cost of developments on the property and that now, when they foreclose, the fund will receive both the land and the developments. Consequently, ORNAX has decided that they will become the first bond fund to actually go through the prolonged legal procedures necessary to repossess these properties, which amount to about 2.5% of their total holdings.
When it comes to high-yield bonds (“junk bonds” as they used to be called), some of them will lose their value entirely. When junk bonds are bought, the buyer understands this possibility (or at least they should have been told this from the person selling them!). Investors accept it because the cash flow from the bonds is so high—the buyer gets paid for taking on that level of risk. ORNAX used to understand that. Investors who bought ORNAX expected the uncertainty and volatility that comes with that risk. Currently, the non-accrual rate for the fund is at 4.8%. Those familiar with junk bonds understand that this rate may vary significantly over time and that the value of ORNAX might fluctuate plenty, even as much as the S&P 500. But investors will still buy, so long as that plentiful stream of tax-free income continues to flow. Put it this way, it took a 50% drawdown in 2008 to get investors to really freak out and start selling.
However, instead of remaining a junk bond buying fund, simply seeking out the highest-yielding municipal bonds, ORNAX’s managers have decided that it may now repossess and manage these foreclosed properties. The bond managers have many ideas about what to do with their newly acquired holdings. Now investors are expected to trust these fund managers to competently manage property that was received from bad bonds. These managers are paid to buy junk bonds. Why should investors believe that ORNAX would do a better job managing the properties than the owners who are foreclosing on them? Realistically, they will probably hire a third party to manage the real estate transactions, but you still have to wonder about a management team that is going outside their core competency of analyzing credit.
Although the Florida dirt bond problem concerns only 2.5% of ORNAX’s assets at this time, what if the problem spreads? What if Obama decides not to back up municipalities? What if Congress determines that they ran out of checks this week or next? Will ORNAX end up owning and managing a significant amount of property? Will this former junk bond fund become a REIT? Probably not, but it seems like unforeseen black swan events are growing by the day.
In the conference call, these managers revealed that they have altered ORNAX’s philosophy from that established by Ron Fielding. While the cash flow and performance of the fund have been impressive, it is no longer the same beast. And who knows how it will act in the future?
Enterprising investors should realize that, though the uncertainty of ORNAX’s changing philosophy leads to a greater risk that is not accounted for in its current price, it could seed an incredible opportunity in the future. If the Florida dirt bond mess spreads and the fund decides to continue to repossess properties, then it will go from holding relatively illiquid municipal bonds to extremely illiquid real estate. This change could cause an exodus from the fund. Considerable investor outflow, together with the challenge of valuing illiquid property in this ‘40 Act NAV mutual fund, could once again cause tremendous opportunity to buy ORNAX at a much lower valuation. Enterprising investors should put ORNAX on their radar—and beware.
Sources:
Lee’s article originally appeared in the New Mexico Business Weekly. It was so well received that it has now been printed in the Orlando Business Journal, where it is no longer behind a subscription wall.
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