Every saver wants a nice, secure investment with a higher yield than can be found in banks.
Most such offerings are merely simulacrums -- delivering high current yields but with only the illusion of safety. And now there's another entry into this lucrative sweepstakes: federally tax-exempt mutual funds invested in limited-term, high-yielding municipal leases. On paper they look pretty safe, but they haven't yet been tested in a prolonged bad market.
A municipal lease is an old form of financing that has recently mushroomed into a $7.5 billion business. Basically, it's an installment contract. Instead of floating a bond issue to buy police cars, hospital equipment, helicopters, computers, modular school rooms and even jails, a city buys them on an installment contract. Investors buy that contract from the seller and receive the city's principal and interest payments.
For investors, muni leases typically yield around one-half of a percentage point more than municipal bonds of similar maturities, according to John Illyes of the research department of John Nuveen & Co., and some yield more. You're getting extra bang for your buck but, in return, you take some extra risks.
Once used mainly for small items, municipal leases are now financing some major projects, especially in real estate. The beautiful part, from a state or city's point of view, is that this form of spending doesn't need taxpayer approval. It gets around legislated debt limits and ducks local taxophobia.
Some leases are small, in the $2,500 area, but most require minimum investments of $25,000 to $50,000, putting them beyond the reach of the average investor.
So, galloping to the rescue, come some mutual funds: the 4-month-old Continental Heritage Tax-Free Income Fund of Denver ($1,000 minimum investment, currently 72 percent invested in municipal leases with the rest in tax-exempt muni bonds); the 1-year-old Municipal Lease Securities Fund distributed by Hutchinson, Fox in Chicago ($5,000 minimum, 95 percent invested in leases); and the Limited Term Municipal Funds of Santa Fe -- a new fund emphasizing California issues and a 3-year-old fund invested in the securities of many cities and states ($2,500 minimum). At present, the Limited Term funds are mostly out of the lease market, because they think they can do better with municipal bonds.
As investors recently learned the hard way, bond-fund values go down when interest rates rise. But the lease funds expect their prices to be somewhat more stable, for two reasons: (1) their short maturities -- right now, two to three years; (2) the fact that lessees make both principal and interest payments every month. That speedy return of principal helps stabilize the price, says Continental's president, Michael Spence.
But there's no free lunch in the marketplace -- meaning that muni leases don't carry their higher yields for nothing: There is usually no guarantee that the city will make its installment payments every year. The money has to be appropriated from the annual budget, and if the budget falls short, so might the lease. For safety, fund managers buy leases principally on essential equipment like telephone systems and snowplows. "We turned down an airplane lease for a governor of a state because we figured if political or fiscal pressures developed, it would be the first thing not appropriated for," Nuveen's Paul Daniels told my associate, Virginia Wilson.
If a city turns deadbeat (which rarely happens), the mutual fund can repossess the property. But there's no guarantee that your fund can sell or release it profitably. There is no public resale market for muni leases. The mutual funds will redeem your shares whenever you ask, but the fund's net asset value (NAV) is essentially a judgment call. In hard times, the NAV could be shaded in the fund's favor.
The funds line up institutions who promise to buy their leases fast, in case money is needed to meet a rush of redemptions. The funds have sales and other charges that eat into their current, 6-plus percent returns: at Continental, a 3.75 percent sales load plus 1.05 percent a year; at Limited Term, 2.75 percent plus 1 percent a year.
On costs, Municipal Lease looks the best -- at a 1 percent sales charge, 0.25 percent a year and an exit fee of up to 1.5 percent if you drop out within 12 months. "It's essentially a break-even operation," says Howard Hutchinson of Municipal Lease. "We make our money on sales commissions, when the fund buys leases from us."
It will take some time and experience before it's known whether the lease funds are really a better buy