By Pat Regnier and Adrienne Carter Reporter Associate: Erica Garcia

(MONEY Magazine) – You never know what Friday the 13th will bring. On that day last October, the Nasdaq had one of its biggest gains ever, leaping 8%. And in Milwaukee, two little mutual funds made their own big moves. On that Friday the 13th, the assets of Heartland High-Yield Municipal Bond and Heartland Short Duration High-Yield Municipal, which totaled $118 million the day before, were slashed to $53 million. High-Yield fell 69.4%, Short Duration lost 44%, and in the blink of an eye, these portfolios--both having boasted perfect five-star ratings from Morningstar, both marketed as low-risk investments, both run by a veteran manager with a superb track record--had become two of the worst-performing mutual funds in history.

What happened at Heartland on Friday the 13th is not just the story of an astonishing portfolio collapse--although it is certainly that. Nor is it simply a tale about the dark side of the junk bond market or a primer about how mutual funds determine the prices for their shares--although what we will tell you here may surprise you. And this isn't only a yarn about a nasty investment dispute--although more than a dozen lawsuits are already flying, and it's probably just a matter of time before the Securities and Exchange Commission swoops down on Heartland with a vengeance.

No, the Heartland story centers around an even more harrowing reality: the risk that lurks within even the safest-sounding investments. It's not just Qualcomm and dotcoms that can lose a fortune in a flash. Like an imperfect gasket in a space-shuttle rocket or a tiny flaw in an SUV tire, some risks are buried so deep that they rise to the surface only when there is a confluence of unexpected, even unimaginable, events. Rare as they are, these events do happen--often just when no one detects a whiff of danger--and there is almost no limit to the damage they can do.

For years, the two Heartland funds had earned some of the highest tax-free yields around, rarely dropping in value by more than a few pennies a share. Heartland's own marketing material showed that Short Duration was just one step up in risk from an ultrasecure money-market fund and that High-Yield was safer than any Heartland stock fund. MONEY's Jason Zweig, among others, was impressed; he recommended Short Duration in one of his columns in 1998. One of its managers even told Zweig the fund was "boring."

If not for a freakish market collapse this past fall, which another fund manager describes as "the perfect storm," the Heartland bond funds might never have burst open to reveal the bizarre risks at their core. And if not for that storm, Heartland's investors would be all the richer and all of us none the wiser about the many gambles these funds were taking. That may be the scariest thing of all about what happened at Heartland.


On the surface, it's hard to imagine an unlikelier place for an investing shock. Heartland manages $2.3 billion for individuals and institutions, and its president, William Nasgovitz, is one of the country's premier small-stock investors. His $900 million Heartland Value has earned an 18.5% annualized return over the past decade, in the forefront of small-cap funds. Prickly, egotistical and iconoclastic, Nasgovitz fearlessly buys the cheapest, smallest stocks he can find.

In 1997, Nasgovitz expanded his bond fund lineup after hiring Thomas Conlin and Greg Winston to launch the High-Yield and Short Duration funds. Conlin, who had spent the previous decade at two prestigious fund firms, Stein Roe and Strong, was a value investor in the Nasgovitz mold. He too looked for bargains off beaten paths. "We shouldn't be able to buy bonds this cheap," Conlin told MONEY brashly in 1998. "But nobody else wants them."

The funds' first couple of years were quiet. But everything turned stormy late last summer: Conlin quit, and then the funds' value was blown away, first in one small gust and finally in a second, fiercer blast. The details remain murky, and different players tell the story in different ways. But here's what MONEY has pieced together after a two-month investigation.

Last August, Tom Conlin told MONEY, he stopped going into the office and was readying himself to take a new job (which, MONEY has learned, was at a financial services firm in Illinois). More than a month later, in late September, Heartland announced that Conlin had resigned. That same day, Heartland shaved 8.2% off the value of High-Yield and 2.1% off Short Duration. As Nasgovitz tells it, just seven trading days later, on Oct. 9, the firm's new bond boss, Philip Fiskow, informed him that a panic was sweeping through the world of high-yield bonds and the market for High-Yield and Short Duration's odd little holdings had all but disappeared. Some brokerages, Fiskow reported, were refusing to trade the very bonds they had helped bring to market in the first place.

"I didn't believe it," exclaims Nasgovitz, recalling that he began contacting brokers himself--and found the situation at least as bad as Fiskow had described. So Heartland dragooned a task force of its executives and directors to comb through the portfolios, bond by bond, and determine how much they could get for each one if they had to sell it right away. The task force met on Friday the 13th--and, in an instant, $65 million worth of shareholder value was decreed out of existence. "It's not good news," says Nasgovitz glumly. "And I'm very sorry for that. But we believe we did the right thing for all shareholders." Soon after the devaluation, MONEY spoke with Conlin, who, bewildered by the markdown, called it "unprecedented." (Conlin has since declined to comment.)


But why would any fund's value ever need to be chopped down by 69.4%, or even 44%, in a single day? To understand why, you need to understand what Heartland owned. Conlin, along with co-manager Winston (who remains with the firm but, like all current members of Heartland's bond team, was not made available to MONEY), invested in high-yield municipal bonds. Issued by state and local governments, municipal bonds pay interest that is exempt from most state and federal income taxes. High-yield, or "junk," munis have low (or no) ratings from bond researchers like Standard & Poor's or Moody's. Like college students getting their first Visa cards, junk munis have to pay higher rates of interest to compensate for the risk of default. But defaults are rare, so diversified junk funds are considered safer than stock funds.

In a market that seems so safe, taking extra risks appears to make sense. Conlin and Winston owned far fewer bonds than their peers--as few as 54 vs. the industry average of nearly 200. They bought small bonds that often were held by only a few other investors. They focused on health-care projects like nursing homes, where yields (and the risk of default) tended to be higher. And last but certainly not least, Conlin and Winston owned junkier munis than virtually any other fund managers in America. As of last June 30, Short Duration had more than 80% of its portfolio in bonds with no credit rating at all, while High-Yield had an astonishing 96% of assets in nonrated bonds. Among 30 high-yield muni funds identified by the researchers at Lipper, the average portfolio had just 40.4% in nonrated bonds.

When we hit the road to see what the projects built by Heartland's bonds looked like, we were vividly reminded why high-yield bonds are called "junk." Take the 7.5% 25-year bonds issued by the Edinburg, Texas Industrial Development Corporation in 1998 to finance the SuperSplash Adventure water park. SuperSplash, in the dusty town of Edinburg just north of the Mexican border, has an impressive array of wave pools and fearsome water slides. But the $18 million park, which opened in 1998, stands quiet now, with rotting oranges littering the pool decks and stagnant water turning green. In September, SuperSplash stopped paying its bondholders. It's not clear if the park, now for sale, will reopen next season; the developer had been counting on attracting crowds of Mexicans across the border, but they never came.

And as of last summer, the two funds had 8% of their combined assets in bonds from two Texas health-care projects. On June 30, the funds together owned what they valued as $4.2 million in bonds from a Houston-area nursing-home project called Sugarland, originally underwritten by H.J. Meyers, a now bankrupt brokerage; they also had another $9.6 million in bonds from assisted-living centers in Fort Worth called Westchester.

Sugarland and Westchester are both connected to a company called Harvest, which is a kind of evangelical ministry for the McDuff brothers--a trio of gospel singers who count Colonel Sanders, the fried-chicken king, among the souls they helped bring to Jesus. The McDuffs developed 13 nursing homes and assisted-living centers across Texas. Unfortunately, Pastor John McDuff, who ministers to a flock near Houston, and his brothers Roger and Coleman had little experience building or running nursing homes. These unlikely executives simply wanted to ensure that no one else would waste away in near squalor as their beloved grandmother had--and to bring God into the lives of the elderly by posting a chaplain at each facility and piping in inspirational programming. John and Roger McDuff each took roughly $75,000 a year in salary from Harvest to spread the word about the homes at churches and community clubs.

The brothers hired outside managers to run the facilities. But they got into the business at the worst possible time, just as government reimbursements to nursing homes began tightening. About a fifth of all nursing facilities in Texas are now in bankruptcy, at least three of the Harvest projects among them.

Quoting Psalm 105:15--"Touch not mine anointed"--John McDuff implies that God views religiously oriented homes like Harvest's with special favor. But there's no doubt that the Harvest homes were troubled. In early October, before Heartland's huge markdown, a bank disclosed that $1.6 million raised for Westchester had been lent to the Sugarland project. Sugarland went bankrupt this past summer and now sits empty, newspapers piling up by its front doors. Westchester's new manager, Jeff Bryant, says he's steadily filling beds. But that $1.6 million is sorely missed. Last fall, Westchester--though still current on its payments to bondholders--went into technical default when it fell short of cash to pay its taxes.


With 20/20 hindsight, all of this sounds scary. But there was nothing in the Heartland managers' track records, or in the bond market itself, to suggest that disaster would strike. In one of his worst years relative to his peers--1991--Conlin still gained 11%. And with their higher income, junk munis usually perform better, not worse, than the rest of the municipal bond market even in bad years. Finally, even if one of Heartland's bonds did default, it would still be worth something. As bondholders, the Heartland funds had legal claims on the real estate and other tangible assets that backed the bonds. Bad debts are usually worked out in the end; unlike stocks, bonds almost never go to zero.

But there was one risk that it seems no one at Heartland had prepared for: What if the market for this junk simply evaporated?

Municipal bonds--especially high-yield munis--don't trade as often, or in as large lots, as stocks do. One fund manager describes the junk muni business as "somewhere between the Nasdaq and the market for Oriental rugs." While a stock like Cisco might trade 100 million shares a day, some municipal bonds go for days, weeks, even months without trading at all. That's because there are more than 1 million different muni issues, many of them tiny. And in search of the best bargains, Conlin and Winston specialized in the munis that traded the least.

In the absence of daily trades, Heartland relied on an outside firm, Interactive Data Corp., to estimate the value of its junk. But Heartland's holdings traded so rarely that actual prices--not just estimates--could differ drastically, depending on how many bonds were involved, who was asking, whom they asked, and when and where the bonds last traded.

In June, for example, J.J. Kenny, another pricing service, had valued the SuperSplash bonds for institutional clients at 40[cents] on the dollar, while Heartland listed them at 77[cents] to 86[cents]. Meanwhile, as of June 30, Heartland priced the Westchester bonds at about 90[cents] per dollar of face value. But MONEY found that the Westchester issues traded several times in May and June for between 51[cents] and 55[cents] on the dollar--and that one nervous investor dumped a block of these bonds for just 28% of their $5,000 face value in early June.

Executives at Heartland insist that until early October, at least, all the funds' bonds were priced correctly. Both Heartland and Interactive contend that tiny and sporadic trades by retail investors are an unreliable guide to the pricing of the large blocks of bonds owned by funds like Heartland's. Concludes Nasgovitz with an air of exasperation: "The [high-yield] muni market is inefficient, that's for sure."

And that's when everything is normal. Last September and October, the price of the average high-yield muni bond slipped, losing about 0.7%--but prices for the kinds of bonds Heartland owned fell apart almost completely as several events came to a head all at once. "Think of a perfect storm," says Reid Smith, who co-manages Vanguard High-Yield Tax-Exempt. "You can see the fronts moving in and colliding." Investors were yanking money out of nearly all bond funds, leaving their managers with no cash to buy the bonds other funds wanted to sell. Health-care related bonds were defaulting by the dozen, and the Federal Reserve was jacking up interest rates.

Suddenly, Heartland found itself in the teeth of a hurricane, and it seems no one knew how to navigate this kind of storm. In normal markets, junk bond investors rarely need to take the first offer that comes along. By waiting a bit, a seller may encounter a buyer who is willing to pay a substantially higher price. But this past fall the market for Heartland's junk wasn't normal anymore, and time seems to have been the one commodity Heartland didn't have. Investors had been cashing out of the Heartland funds all year, redeeming roughly $50 million worth of shares by Sept. 30. The funds were getting down to their bottom dollars. Heartland's July 1 shareholder report revealed that the two funds had borrowed $23 million from Deutsche Bank in part to help meet redemptions.

Late in September, Heartland sold $8.3 million of its muni junk to the State of Wisconsin Investment Board to raise cash. Heartland guaranteed Wisconsin a 20% annual return over two years, backed by the firm's and Nasgovitz's own money. The move has raised a stink in Wisconsin, because Jon Hammes, the chairman of the state board, is also a director of the Heartland funds. (He recused himself from the board's decision.) Nasgovitz sees no conflict of interest. "All people are doing," he fumes, "is trying to pick on us."


Mutual fund investors worry about lots of things: Maybe the whole market will go down and take your index fund with it, or the manager at your hottest fund will up and quit, or you'll get whacked with a big tax bill. But you probably don't lose much sleep worrying that your fund might turn out to be worth much less than its officially reported value.

Tom Tuttle certainly slept well. After doing plenty of homework to research the fund, the San Diego retiree moved $25,000 into Heartland High-Yield Municipal in 1998. Tuttle, now 59, wanted something less risky than a growth fund but with a little more kick than most bond funds. He knew very well that bonds could lose money; back in 1994, Tuttle had watched the value of his Orange County bonds spiral downward when that California municipality went bankrupt. But he never expected anything like the $16,000 one-day hosing he took in his Heartland fund. "I was confused," recalls Tuttle, "like 'What the devil happened here?'"

No one is saying that the Heartland fiasco means that all mutual funds' prices are unreliable. But former Salomon Bros. economist Henry Kaufman has long warned that mutual funds offer "the illusion of liquidity," since their reported net asset values might not mean much if markets go mad. Municipal junk funds are not the only place where liquidity could turn out to be an illusion. Microcap, bank prime rate and emerging market stock and bond funds--as well as real estate, commodities and partnerships--all harbor the same hidden risk.

In fact, the value of every investment assumes that markets will remain normal; in abnormal conditions, like a perfect market storm, prices can get blown to oblivion. That's what happened in the fall of 1998, when the Nobel-prizewinning geniuses at the Long-Term Capital hedge fund nearly wrecked the global financial system as the markets for their holdings blew up. That's what happened to value investors who didn't buy Internet stocks in 1999--and to growth investors who did in 2000. In the end, what happened at Heartland should teach us all that there's no such thing as perfect safety--and that markets exist not just to make us rich but to humble us when we least expect them to.