What Happened to Muni Closed-End Funds?

The closed-end muni universe has collapsed and continues to sink. Why are these yields being ignored?

-- Michael Glen

Michael,

Municipal bond closed-end funds are indeed in terrible shape. But analysts say the time to stop ignoring the value they represent, if not already at hand, is not far away.

Muni bonds themselves are on sale big time, in part because interest rates have risen this year and in part because much of the institutional demand for munis dried up this year.

All bond prices have fallen this year because that's what bond prices do when interest rates rise. And in the muni market, insurance companies -- a cornerstone of the demand base for munis -- haven't been buying. As a result, the key measure of value in the muni market -- the percent of taxable Treasury yields that can be obtained from tax-free munis -- has rocketed. In June, the yield of the Merrill Lynch Municipal Master Index was 88% of the yield of the Merrill Lynch Treasury Master Index. Earlier this week, the muni yield was 96% of the Treasury yield.

As muni bond prices have fallen, so have muni bond fund share prices. The average open-end intermediate muni bond fund was down 2% through the end of October, while the average long-term fund was down 4.6%, according to Lipper.

The damage has been even worse in closed-end muni bond funds, where most net asset values have fallen further than open-end fund NAVs because muni closed-end funds often use leverage, which magnifies both gains and losses. The funds leverage themselves by issuing preferred shares, on which they pay short-term interest rates, and investing the proceeds in long-dated securities.

In addition, muni closed-end fund share prices have dropped even further than their NAVs. At the end of last year, the average national muni closed-end fund traded at a 0.7% premium to NAV, according to First Union Securities. Last Friday, the average fund traded at a 8.02% discount.

Muni Closed-End Funds -- Cheap! The average premium/discount for national muni bond closed-end funds.

Source: First Union Securities

The discounts have widened for at least three reasons, closed-end fund analysts say.

First, it's just a maxim that when closed-end fund NAVs are falling, share prices fall even more since investors tend to sell funds whose NAVs are falling. "Almost without exception, market prices go down further than NAVs," Prudential Securities closed-end fund analyst Kristoph Rollenhagen says.

Second, the muni closed-end fund universe has been flooded with new supply this year, Gruntal closed-end fund analyst Michael McGrath points out. Through the end of September, there were 22 initial public offerings, compared with 10 last year and four the year before. The supply started coming early in the year, when the average fund traded at a premium to NAV after spending most of last year at a discount.

The fresh supply was particularly appealing this year, McGrath says, because so many muni closed-end funds were created in the early '90s. Because most muni bonds become callable by the issuer 10 years after they are issued, and because interest rates were so much higher then than now, many old funds are in danger of having high-coupon bonds called away in the next few years. When that happens, funds have to replace the called issues with new, lower-coupon issues, a process that normally leads to dividend cuts. Closed-end fund investors can sell an old fund at a discount, realize a tax loss, and replace it with a new fund offering many more years of call protection.

Tax-loss selling is the third reason why muni closed-end funds have suffered so much lately. Investors have been selling muni closed-end fund shares to realize losses that can be used to offset gains taken elsewhere in their portfolios with a vengance not seen since 1994, the last time the average discount was as low as it is now, says Mariana Bush, closed-end fund analyst at First Union.

Buy Now?

So, when can you take advantage of the extreme cheapness of muni closed-end funds and buy them?

Bush, noting that the average discount as she measures it bottomed two weeks ago at 10.4%, thinks the answer is now. "Tax-loss selling is going to end at some point, and it's probably not Dec. 31. It's probably going to be before then," she says.

Rollenhagen agrees: "For the right funds, you can pick up 110% of Treasuries, paid monthly, with eight to 10 years of call protection," he says. While it's possible that tax-loss selling will drive discounts even lower before the year is out, to the extent that investors replace sold shares with shares of a similar fund (the wash sale rule won't let you sell a fund to realize a loss and then buy the same fund right back), tax-loss selling won't hurt share prices, Rollenhagen points out.

Gruntal's McGrath is more cautious, expecting discounts to widen further by year-end due to tax-loss selling. But he says buying at this stage is a safer bet in national funds and large single-state funds focusing on California and New York than in smaller single-state funds, which remain vulnerable to competing IPOs.

Interest rates are the wild card. If they turn tail, all bets are off. But if they keep improving, this is almost certainly a sweet entry point into muni closed-end funds.

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