Lee Eugene Munson and Lorraine Ell provide independent fund research on the Oppenheimer Rochester National Municipal Fund (ORNAX, ORMBX, ORNCX).

At the most basic level, most analysts simply lack an understanding of the Oppenheimer Rochester National Municipal Fund (ORNAX, ORMBX, ORNCX) managed by Ronald Fielding. Most analysis of ORNAX highlights parts of the portfolio without context and paints the fund as risky, not suitable for a core municipal bond portfolio. Although the short-term volatility of ORNAX is higher than the average AAA rated muni fund, over time it has produced outstanding results. To paraphrase Buffet, we would rather take a lumpy 14% than a smooth 12%, or in the case of munis, a smooth 3%.

An opportunity to achieve outsized gains must have some degree of mispricing among market participants. Ronald Fielding, lead manager, takes advantage of this mispriced market that, historically, few have attempted to exploit.

To start off, most of the retail crowd that invests in muni bonds is looking for a safe, tax free alternative to the US Treasury market, or a way to avoid paying tax regardless of the after tax yield. The recent crisis of confidence of the monoline muni insurance carriers has brought forth the reality that nothing is risk free, including long-term treasuries. The very concept of taking on more risk and then attempting to hedge that risk away is unattainable on a long term basis if practiced by too many participants. In essence, it can only be done if mispricing occurs and only a few investors exploit it. You get rid of risk but you lose return. You can, however, increase your return if the security is priced irrationally.

The ORNAX portfolio is determined by opportunity in the markets. What you end up with is value investing in municipal bonds, picking the best available investment at any given time. For instance, NY Port Authority bonds were paying 20% earlier this year for a few months until the bonds could reset. While a short-term situation, the value was there. Also, value can be found through superior analysis of the credit worthiness of municipal bonds. Tobacco revenue bonds, although considered riskier than AAA GO bonds, are long term and offer potential for excess return. To fully understand the risk involved, let us examine these bonds closely.

Tobacco revenue bonds have figured prominently in the ORNAX portfolio for many years. In 1998, 46 states and originally four (now over 30) tobacco companies entered into a Master Settlement Agreement (MSA). This settlement ended the states’ ability to sue the tobacco companies. Some of the participating states issued municipal bonds backed by annual payments from the MSA, and these bonds are commonly referred to as “tobacco bonds”. Opportunity exists here. States need the MSA revenue to supplement their budgets. In 1999 New York State decided to get the settlement money up front and issue muni bonds that were backed only by the MSA. Then we had some states issue double-barreled bonds that the state pledged to back up if the tobacco firms were unable to make MSA payments. Finally, there are states that didn’t float bonds and simply take the revenue directly from the tobacco companies. The bottom line is that the public and private sector are tied at the hip on the MSA. You could say the double-barreled bonds seem the safest, but the real return is in the single-barreled tobacco settlement bonds. This year, tobacco settlement bonds were helped by the spinoff of Phillip Morris International, leaving the domestic Altria with no exposure to international legal risk, which could have a positive effect on the companies’ ability to make MSA payments. We also still see a structure discount due to the extra layer of credit analysis needed. The MSA settlement documents are difficult to understand and are widely misunderstood. This inherent complexity has a propensity to be mispriced. The perceived riskiness of the bonds dissipates as we start to see how the government has a strong vested interest in the success of the MSA and participating tobacco companies. ORNAX looks for opportunities such as these to get paid as much as possible for taking risk.

Interest rate risk also matters and ORNAX is designed to be interest rate neutral. Most investors are familiar with bond laddering as a method of taking an interest rate neutral stance. Laddering is a simple concept that involves buying multiple bonds at different maturities, a strategy employed by many muni bond funds. Thus, you get a consistent stream of bonds maturing. Your 30-year bonds become 29 years and your one-year bonds that come due are reinvested in 30-year bonds. By buying bonds with a staggered maturity, you end up with a constant stream of short bonds coming due and being replaced with longer maturities. While an excellent strategy, ORNAX is not in the business of laddering or looking for an even duration. Fielding is looking for value, and that usually does not come in a tidy little package of staggered maturities. So ORNAX uses an alternate system to offset interest rate risk.

ORNAX invests in inverse floating rate securities, sometimes called “inverse floaters”. In October ORNAX had over 20% exposure to these securities and can hold more if needed. An inverse floater is a structure, not a bond. By placing a regular bond in a trust the interest and principle payments can be separated. ORNAX is interested in the part that pays a rate inverse to the direction of interest rates. So, if rates go down, the payment increases and if rates go up, the payment decreases. Obviously, someone has to take the other side of that structure. Money market funds are the likely buyers of the variable rate demand note (the “floater”), the value of which is supplemented by cash flow from the inverse floater when interest rates rise. If you only take this small amount of information, you might get the idea that ORNAX is playing a risky game of guessing the direction of interest rates. In fact, you would be wrong.

Now we get to the heart of the matter. ORNAX strategically uses inverse floaters in conjunction with premium coupon callable bonds. This is a bond that pays more than market rates and sells for over par. If rates go down, the inverse floaters will pay more, but the premium callable bonds will most likely get called away and refinanced. If rates go up, the inverse floaters will pay less, but the callable bonds will most likely not get called and keep paying the higher than market rates. By using this strategy, ORNAX mitigates interest-rate risk while maintaining a very attractive cash flow. If fact, it seems riskier to take a 10-year treasury and bet that you know what the interest rate environment is going to be over the next ten years. Don’t even try it.

The bottom line: this is a high yielding fund that gets paid for taking carefully measured risk on tax-free bonds. The reasons this opportunity exists are three fold. First, ORNAX employs superior credit analysis, and looking for opportunity not simply copying a muni bond index. Second, ORNAX has the courage of conviction to invest in places the market fears to tread, which can be humbling over short-term periods. Third, the inability for market participants to see muni bond investing as primarily a cash flow tool and not a safe haven for capital creates opportunity for ORNAX. This last point is key. If people start to change their minds about how to approach the muni bond market, I believe the excess returns of ORNAX would dissipate. Do not hold your breath.

We see the place of muni bonds as beating inflation on an after tax basis over time, not a safe haven. The fact that investors view the asset class differently from the fund provides opportunity. The general concept of ORNAX is that long-term returns on muni bonds are generated from high yields. Over time this is supposed to trump short-term volatility. What we get are long periods of outperformance followed by sharp declines and fund outflows. So, there are optimal times to acquire the fund’s shares.

As we write this article, we have every confidence that the general public will continue to buy high and sell low due to ignorance. Over the last ten years the average return for investors has been very different from that of the total return of ORNAX. This is evidenced in part by the inflows and outflows of the fund over the years. Huge amounts of cash flooded the fund at the end of 2006, near the peak of the municipal bond market. There is no mystery here, just the crowd jumping in near the end, chasing yield, and not wanting to ask about the risks. Once the markets began to swing, investors became more cautious, although ORNAX has had positive flows through 2008, which has helped the fund to take advantage of market conditions.. Bonds that the fund has sold in 2008 have generally been those that can attract bids from retail investors, with proceeds re-deployed in cheaper, lower-rated and higher-yielding paper (they do not fire sale assets that ‘look risky’ just to window dress the fund). Market conditions have also offered managers the opportunity to generate tax-losses, which offer current and future investors the hope that no material capital gains, if any, will be distributed when the municipal bond market regains some semblance of normalcy.