How Are Muni Closed-End Funds Looking?

How do closed-end muni funds look now compared to in November? It looks like they rose early in 2000 and have now sunk back to their year-end lows.

-- Tim Clark

Tim,

It's true: Many municipal bond closed-end funds are trading at discounts as wide or wider than they were in December, when tax-loss selling savaged the sector.

According to Lipper, the average national muni closed-end fund traded at a discount of 13.1% to its net asset value at the end of last year. The discounts narrowed in January. But by the end of the first quarter, the average discount was back up to 12.5%.

Discounts have widened even as the muni market has rallied, boosting the net asset values of many funds, notes Mariana Bush, closed-end fund analyst at First Union Securities. "Prices have moved up, but not in proportion to NAVs," she says.

Closed-end fund analysts don't have a whole lot of confidence that discounts will narrow any time soon, particularly not for leveraged funds. Those discounts could even widen further, they say.

Leveraged closed-end funds attempt to boost their returns by borrowing money at short-term interest rates and investing it at higher, long-term rates. It's a profitable strategy -- except when the Fed is hiking short-term interest rates, as it has been doing since June and is expected to continue. That increases leveraged funds' cost of money, and can force them to cut their dividends.

At the same time, it's hard to imagine discounts widening much more, particularly for funds that aren't leveraged, analysts say. And in the meantime, the yields are fantastic. At current discounts, many muni funds have current yields in the neighborhood of 7%, which equates to a taxable yield of 11.5% for someone in the top bracket. "The discount more than compensates for interest-rate risk," says Paul Mazzilli, director of closed-end fund research at Morgan Stanley Dean Witter. He says he'd be surprised to see discounts widen much more.

Some analysts remain extremely wary of the leveraged variety, however. "Non-leveraged portfolios are the way to go," says Michael McGrath, closed-end fund analyst at Gruntal. "Leveraged funds are being squeezed, and it's starting to affect dividends. The more the Fed raises rates, the more dividends are going to get squeezed" -- and the more discounts can widen.

Kristoph Rollenhagen, closed-end fund analyst at Prudential Securities, agrees it's wise to steer clear of leveraged funds. He downgraded "damn near everything leveraged" in mid-February, after Prudential's chief economist Richard Rippe predicted the Fed would hike rates by a full percentage point by mid-year. The Fed has already hiked the fed funds rate by half a percentage point in two steps, one in February and one in March.

As ever, analysts favor funds that acquired most of their bonds recently enough that they do not have to worry about having issues called away -- a development that can lead to dividend cuts. Both McGrath and Rollenhagen like Nuveen Select Tax-Free Income Portfolio (NXP), Nuveen Select Tax-Free Income Portfolio 2 (NXQ) and Nuveen Select Tax-Free Income Portfolio 3 (NXR), unleveraged funds with discounts in the 8% to 12% range.

Rollenhagen also likes Morgan Stanley Dean Witter Municipal Income Trust (TFA), Morgan Stanley Dean Witter Municipal Income Trust II (TFB) and Morgan Stanley Dean Witter Municipal Income Trust III (TFC). These funds trade at even deeper discounts, and Rollenhagen says they will become preferable to the Nuveen funds after a year or so, when the Nuveen funds "will be running into call issues."

Bush likes the first Morgan Stanley fund mentioned above and Nuveen Municipal Value (NUV) among non-leveraged funds, and is more cautiously recommending leveraged funds Municipal Advantage Fund (MAF) and Nuveen Insured Premium Income Muni Fund 2 (NPX). She thinks there's enough of a chance that discounts will soon begin narrowing, benefiting leveraged funds the most, that it's worth taking the extra risk these funds entail.

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