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Buy Muni Funds After Dividend Cut

NEW YORK (TheStreet) -- Most bond funds have suffered lately, but the damage has been particularly severe for closed-end municipal funds. Many of those have declined more than 12% this year, compared to a fall of 3.0% for the Barclays Capital U.S. Aggregate Bond index.

Now some bottom fishers argue that the closed-end funds sell at bargain prices. The bulls note that the tax-free funds yield 6%. That's the equivalent of a taxable bond that yields more than 9% for high-bracket investors. "Investors will come back to the closed-end funds because the yields are attractive," says Patrick Galley, portfolio manager of RiverNorth Core Opportunity (RNCOX), a mutual fund that invests in closed-end funds.

Climbing interest rates have caused the rout. When rates climb, most fixed-income funds tend to fall as investors sell existing bonds with low yields. But closed-end funds can suffer the most severe damage. Closed-ends hold portfolios of stocks or bonds. The funds issue a fixed number of shares that trade on stock exchanges. During bull markets, the fund shares can sell for premiums to the value of the assets in the portfolios. In hard times, the shares can slip to discounts.

While all kinds of closed-ends can sink, municipal funds can be especially volatile because they are owned mainly by income-oriented retail investors. At the first sign of trouble, the shareholders tend to dump their funds. A year ago, many investors were racing to buy bonds, and the municipal closed-ends sold at premiums. Then in recent months, many funds slipped to 5% discounts.

Some funds suffered particularly steep losses because they cut their dividends in recent months, says John Cole Scott, portfolio manager of Closed-End Fund Advisors. The funds held bonds that had been purchased several years ago when yields were higher. After the bonds matured, managers were forced to buy lower-yielding new issues. As a result, portfolios generated less income, and managers cut payments to shareholders.

After dividend cuts, many shareholders become angry and dump their funds. That can create bargains, says John Cole Scott. "The time to buy municipal funds is just after dividend cuts," he says. "People dislike those funds, even though they may still have good prospects for producing solid total returns."

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