Whodunit? ‘Twas pricing agency, maybe, some say

After one of the strangest episodes in recent memory involving muncipal bond pricing, people are beginning to point fingers – and not at the usual suspects.

While the cause is still far from certain, the bond pricing agency appears to be at least partly responsible for massive write-downs in two high-yield municipal bond funds managed by Heartland Advisors Inc. in Milwaukee, according to a number of sources.

Early on, much of the suspicion was focused on what appeared to be the sudden departure of one of the portfolio managers, who now says the company knew all along he was leaving.

After repricings about two weeks ago, Heartland’s High-Yield Municipal Bond Fund lost 70% of its net asset value, and its Short Duration High Yield Municipal Fund lost 44%. Those write-downs followed smaller repricings by the company’s pricing service Sept. 28.

Those familiar with the situation say the Securities and Exchange Commission is looking into the write-downs.

Most experts believe the agency will focus on one or a combination of three possibilities: that Heartland was the victim of an illiquid market; that the fund managers were padding their performance; or that the pricing agency used to value the bonds blew it.

“What we think happened was after the initial repricing in September, Heartland went to sell a lot of these bonds to meet redemptions,” says Chris Kelsch, an analyst with Morningstar Inc. “They soon found out they couldn’t get nearly what they thought for them and had to reprice the bonds.”

Heartland’s pricing agency, Interactive Data/Financial Times Information in New York – formerly Muller Data Corp. – did not return calls for comment.

But Art Brasch, director of the agency’s municipal services, confirmed in the Oct. 20 edition of the Bond Buyer, a trade paper, that the SEC had made an “informal request” for information regarding high-yield municipal securities.

Illiquid security

It may be a long-overdue peek into the world of pricing.

Pricing agencies are used by fund companies to determine the value of a security if its value can’t be set based on past trading activity.

Steven Peterson, a vice president and portfolio manager with Nuveen Investments in Chicago, says reasonable people can differ slightly about the value of an illiquid security. But he has seen instances that left him wondering what the pricing agencies were thinking.

Most bond fund managers, however, say Interactive Data, along with its rival J.J. Kenny in New York, a unit of Standard & Poor’s, are reliable. The two companies are the dominant pricing players.

“The pricing services may have some inherent lags built in; they may not catch up immediately with a huge swing in the market, but in a fairly short period of time they’ll catch up,” says Gary Madich, chief investment officer for fixed income at Banc One Investment Advisors Corp. in Columbus, Ohio.

Even if they don’t catch up, it’s still the responsibility of the fund company to make sure that the prices set by the agencies are correct, says Douglas Scheidt, an associate director in the chief counsel’s office of the SEC’s investment management division.

For its part, Heartland is not blaming Interactive Data. According to a prospectus supplement it filed with the SEC, the write-downs were in response to a “lack of liquidity” in the muni junk bond market.

Doug Lucas, a spokesman for the company, said Heartland would not comment further.

Equity carnage

Tom Metzhold, a vice president and portfolio manager with Eaton Vance Management in Boston, says he finds the liquidity excuse hard to believe.

“I actually believe the liquidity in the high-yield muni market is better today than it was a year ago, primarily because of the carnage in the equity markets,” Mr. Metzhold says.

Although Heartland says Thomas Conlin, co-manager of the two Heartland funds hit with repricings, was not forced to leave, his departure the same day as the repricing in September seemed more than coincidential to some.

But Mr. Kelsch says he received a letter from Mr. Conlin saying he actually gave notice Aug. 17 to pursue other business opportunities. Mr. Conlin says in the letter that the repricings had nothing to do with his leaving.

His co-managers, Greg Winston and Derek Pawlak, as well as Philip Fiskow, a senior vice president and director of fixed income, are still with the company.