May 22 (Reuters) - After Detroit filed for bankruptcy last summer, portfolio managers at Eaton Vance municipal bond funds saw a gem hidden in the plumbing of the beleaguered Midwestern city.
As the prices of 30-year bonds backed by Detroit's water and sewer system plunged, the Boston-based firm swooped in to become the top investor in them.
The bet paid off as the Detroit bonds recovered to nearly full value, helping the $763 million Eaton Vance High-Yield Municipal Income Fund post a 10.76 percent year-to-date return. That is nearly double the 5.39 percent average return across nearly 600 municipal funds tracked by Lipper Inc, and ranks it No. 9 among U.S. municipal bond funds.
Eaton Vance's payoff is just one example of the recovery of municipal junk bond funds so far this year, after a tough 2013.
Using plays on land, low borrowing costs, and distressed debt, junk bond funds are the best performers in the municipal category so far in 2014. They've rebounded from last year's credit panic when Detroit's bankruptcy and Puerto Rico's chronic fiscal woes triggered nearly $60 billion in net withdrawals by investors from muni bond funds.
Eaton Vance portfolio manager Tom Metzold said the bet on Detroit was no sure thing, but that risk was limited because the city's water and sewer authority provides services well beyond city limits. Repayment of the bonds isn't tied just to Detroit residents, but to an area that includes about 50 percent of Michigan's population - much of it in a lot less fiscal distress than Detroit itself.
Prices on the bonds dropped to 77 cents on the dollar late last year, only to rise to about 99 cents this month. In February, Detroit said water and sewer bondholders would receive full recovery, while investors in other bonds issued by the city would receive only between 10 cents and 30 cents on the dollar.
Funds run by Eaton Vance are not only enjoying price appreciation on the water and sewer bonds, they also get an annual coupon rate of 5.25 percent. Eaton Vance funds and investments strategies owned about 36 percent of the $224 million bond issue, as of March 31, according to Thomson Reuters data.
Eaton Vance bought some of the bonds last year at around 90 cents on the dollar, Metzold said. It bought more earlier this year as the price of the bonds traded between 77 cents to 84 cents on the dollar, providing annual yields of about 6 percent to 7 percent.
And he stressed that the firm isn't only looking for a short-term profit.
"We're not buying credits that look good for one or two years, but for 10 to 20 years," Metzold said.
Municipal junk bond funds also have been helped by the recovering housing market, which has lifted the value of land-backed development bonds, said John Miller, co-head of fixed income at Nuveen Asset Management LLC. The so-called dirt bonds got crushed during the housing crisis and remain a core holding for many municipal junk bond fund managers.
In addition, muni bond managers of all stripes are taking advantage of ultra low short-term interest rates to borrow money to buy long-term bonds. Because the yields on the long-term bonds are higher than they pay in interest to finance the transaction, the funds can take advantage of the difference, generating extra income for their investors. The borrowing rate is reset weekly off the Securities Industry and Financial Market Association Municipal Swap Index. SIFMA's variable rate is currently 0.08 percent.
"It's been one of the best markets ever for this strategy," Miller said. He said Federal Reserve Chairman Janet Yellen's recent comments indicating that rates will stay low for some time to come should mean that the strategy has staying power.
The performance of junk bonds may be getting noticed. After pulling $10 billion from municipal junk bond funds last year, investors have piled back in with year-to-date net deposits of $4.3 billion, according to Lipper, a unit of Thomson Reuters.
Funds run by OppenheimerFunds, part of insurer MassMutual Financial Group, were among last year's worst performers because of their heavy bets on Puerto Rico. But those funds have recovered this year as Puerto Rico bonds have rallied from rock-bottom lows. The S&P Municipal Bond Puerto Rico Index, which measures the performance of bonds issued by the Caribbean island, is up 9.53 percent this year.
The $127 million Oppenheimer Rochester Virginia Municipal Fund is the No. 1 performing municipal bond fund tracked by Lipper, posting a year-to-date return of 12.85 percent, after losing nearly 16 percent in 2013. The fund's largest holdings include Puerto Rico debt and junk-rated tobacco bonds.
Meanwhile, the worst performing municipal bond funds in 2014 don't have credit risk problems. They're mostly conservatively run funds that offer investors more yield than a money market fund, but have been hurt by Federal Reserve policy that has kept short-term interest rates at historically low levels.
"We straddle both worlds," said Doug McGinley, who runs the Fidelity Conservative Income Municipal Bond Fund. "We provide more yield than a money market fund, but we are a bond fund that's safer than most bond funds."
Launched in October amid a credit contagion in the municipal bond market, the $90 million Fidelity fund is up 0.19 percent this year, second-to-last among municipal bond funds tracked by Lipper. But that's OK with investors who want little risk and were only getting a 0.01 percent return from a typical money market fund. His fund has a short duration, which means it is less sensitive to rate moves. Longer duration funds currently are performing better, but any sudden rise in interest rates will hurt them.
"There's still enough people concerned about what can happen when interest rates rise," McGinley said.
(Reporting By Tim McLaughlin; Editing by Richard Valdmanis, Martin Howell)