(Bloomberg) - Brian Katz was at his son’s college graduation from Northwestern University in June when he got a text from his financial adviser saying they needed to talk. A few days later the adviser told Katz that the municipal bond fund he put money in since 2022 had suffered major losses.
Katz’s stake in the open-end Easterly Funds’ RocMuni High Income Municipal Bond Fund tumbled 50% in two days, a stunning move in the staid world of municipal bonds, an asset class that tends to provide steady returns.
“I was shocked,” said Katz, who thought he was buying a conventional muni fund. “I’ve never had anything like that happen before, where money just disappears.”
Even before its collapse, the Easterly fund, at $245 million under management as of February, was miniscule by Wall Street’s standards. But its implosion highlights the dangers lurking in high-yield munis, a risky corner of the state and local debt market where bonds tend to trade sparingly, if at all, and price discovery is elusive. Investors, like Katz, can be blindsided when sudden outflows force fund managers to unload troubled assets at prices far below the estimated values they had set.
In Easterly’s case, that meant selling unrated bonds for pennies on the dollar to meet investor redemptions. A third of the fund’s holdings were in default, according to the company’s filings with the US Securities and Exchange Commission.
The Easterly fund had a 6.7% yield as of May 31, the highest among more than 60 high-yield muni funds, according to Morningstar Direct data. The cohort has taken in $6.1 billion through August, representing 20% of total inflows into muni open-end and exchange-traded funds.
“If it has the highest yield of any of the options out there or even among the highest there’s a reason for it,” said Eric Jacobson, senior principal, fixed income strategies, at Morningstar. “There’s no free lunch.”
Already the Boston-based fund company has been hit by two shareholder lawsuits, alleging the fund inflated the value of some of its assets and materially misrepresented its exposure to illiquid securities. Meanwhile, Katz has filed an arbitration claim against his financial adviser.
“The fund values its holdings in accordance with widely accepted industry best practices,” said an Easterly spokesperson, who declined to comment on the fund’s performance.
The Easterly fund primarily focuses on unrated debt issued by government entities to finance private-sector projects with public benefits, like recycling plants and senior-living facilities. These bonds are backed mainly by revenue from projects which are less stable than conventional munis backed by tax revenue.
The fund’s offering materials disclose risks, including that the price they could receive when selling a bond could differ from the fund’s valuation, particularly for securities that trade in thin or volatile markets, the spokesperson added. The documents said the fund expected to invest the majority of its assets in junk or unrated bonds.
Overall, high-yield bonds represent about 10% of the $4.2 trillion muni market, according to Eric Kazatsky, a managing director at MacKay Shields.
Lack of Transparency
The overwhelming majority of bonds trade over the counter, unlike stocks which trade on centralized exchanges and whose share price is determined at the close of a trading session. As a result, bond funds don’t have access to a single closing price for each individual debt issue.
Without readily available market quotes, bond funds use third-party pricing services to set the daily value of their portfolios and the funds’ share price.
“A pricing service really has little to go on other than comparing them to other similar bonds,” said Jacobson.
Securities regulations require a fund’s board or its designee to oversee third-party pricing services and evaluate their methodologies, according to JR Rieger, a former head of securities evaluations at S&P Global Inc., adding that fund managers have an obligation to reflect current values.
Moreover, in the buy-and-hold muni market, only 1.4% of the roughly 1 million outstanding securities typically trade on an average day, according to the Municipal Securities Rulemaking Board.
‘Eye of the Beholder’
Beginning in April, when US President Donald Trump’s “Liberation Day” announcement of widespread tariffs sparked broad market turmoil, investors began pulling cash out of the Easterly fund at a rapid clip. Estimated outflows in April totaled about $24 million, according to Morningstar Direct data, followed by $21.5 million in May.
Still, the fund was able to sell more widely held bonds that weren’t in default at discounts of 10% or less and in some cases premiums to Easterly’s valuation, according to a Bloomberg review of the portfolio and trade data.
But as investors continued to yank cash, including almost $17 million on June 3, Easterly sold its most illiquid debt 10 days later. It unloaded at least 38 bonds — 18 of which were in default — at discounts as high as 100%, according to a review of publicly available portfolio and trade records.
Of the roughly 90 municipal securities in Easterly’s high yield muni fund on May 31, more than 90% were unrated and about a third were in default, according to the company’s filings with the SEC.
About $9 million of defaulted securities issued for a Kentucky facility built to turn cooking oil into biodiesel traded for 3 cents. Another $7 million of bonds that financed a dock and wharf in Texas traded for 6 cents. Both securities were issued on behalf of affiliates of Jefferson Enterprise LLC, a Spring, Texas-based energy company whose founder and Chief Executive Officer Al Salazar died of cancer last October, according to a securities filing.
Two weeks before, Easterly had valued the bonds at 70 cents and 90 cents respectively, based on third-party valuation services.
“A lot of it’s in the eye of the beholder, but what makes it definitive is if somebody tries to transact on the valuation and the market gives you the Mike Tyson punch in the face,” said Tom Doe, founder of Municipal Market Analytics.
