Spooked by rising interest rates and distribution cuts, day traders and other individual retail investors are fleeing closed-end funds that specialize in municipal bonds.

But while some of the smaller fry see trouble ahead, some veteran investors see a buying opportunity in this specialized niche of the financial world.

Because of the unique way closed-end funds operate, the stock price floats unattached to the net asset value of the portfolio of stocks inside the fund and can often trade at a discount.

As small-time investors bail they are driving down the price of closed-end muni bond funds. And that, in turn, is creating even deeper discounts compared to the net asset value of the underlying assets.

For investors, the discounts mean the ability to snap up a dollar's worth of stocks and bonds for 90 cents, for example.

Unlike open-end mutual funds, which dominate the market, closed-end funds, whether they specialize in munis or equities for that matter, trade freely through the day, with only a set number of shares issued.

However, as in most things in life, timing is everything.

And while some investors who specialize in closed-end muni bond funds see a buying opportunity now, others say the time is not yet ripe for pulling the trigger.

The Case For Buying Now

"This is the time to get in if you can hedge out the interest rate risk or if you are worried rates may rise further," says James Robinson, a veteran bond trader and chief executive of Robinson Capital in Grosse Pointe Farms, Mich.

In particular, Robinson doesn't see the bargains getting that much juicier than they are now.

Closed-end muni bond funds are already sporting discounts in the 9 percent range and haven't been lower in a decade.

"The only time they hit this 8% or 9% discount, they bounce back," Robinson notes. "The only time they went lower was in 2008."

Behind the discounts has been a flurry of distribution cuts by managers of closed-end muni bond funds.

Blackrock recently announced distribution cuts to 20 of its closed-end funds -- 18 of them were muni funds.

While it's possible that the selloff in closed-fund muni bonds could further widen the net asset value discounts to even the 10% range, this is likely to be only a temporary shift.

"It could get to 10%, but it won't last for long," Robinson argues.

There are other factors that are working to limit declines in closed-end muni fund prices, Robinson says.

The five or six big fund companies that focus on closed-end munis have effectively put a floor under the sector, stepping in to buy back stock when the discounts threaten to get too steep. This happened in February, when trading volumes tripled, Robinson says.

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For individual investors eyeing the muni sector, the closed-end fund structure also offers some key advantages over going it alone and simply buying muni bonds directly.

This is especially the case in a period of rising rates, when even a 1% increase in rates has the potential to trigger a 10% decline in net asset value.

Closed-end fund companies can "hedge out a lot of the interest rate risk" on net asset value by taking short positions in U.S. Treasury future contracts, Robinson says. Closed-end muni funds currently average a 4%, tax-exempt return.

"Discounts are at historic wides," Robinson says. "They may not get better but they will not get worse."

The Case For Waiting

Greg Neer, a partner and portfolio manager at Relative Value Partners, a wealth management firm based in Northbrook, Ill., says his firm hasn't owned many municipal bonds over the past few years but is starting to take more interest. "We are starting to look at them more closely and selectively pick at some," Neer notes.

But RVP's timeline is a bit different. Rather than plunge in now, the wealth management firm sees a better buying opportunity emerging towards the end of 2018.

The Fed has indicated it will continue to raise rates. That will increase the cost of leverage for closed-end fund managers, who can borrow to buy in order to enhance returns, unlike their open-end mutual fund counterparts, Neer contends.

That could lead to further dividend cuts, prompting more selling of closed-end muni funds by smaller, retail investors.

Another factor that could lead to a year-end sales surge is the prospect of having to pay capital gains taxes on high-flying tech and other equity funds. Some investors may decide to cash out of their closed-end muni-bond funds in order to foot that bill, Neer predicts.

"I think there are a lot of things that can play out between now and year end," Neer says. "We should have slightly more clarity from the Fed and where they plan to go." By pushing out the buying decision "we are giving ourselves more time for adjustments in the yield curve," he adds.

A Good Time to Go Muni

Still, Robinson argues that favorable developments in the muni sector bolster the case for jumping in now with a closed-end fund.

Muni bonds are in short supply for one, with just $2.5 billion in new issues available in the past 30 days compared to $11-$12 billion on average historically.

The Trump tax reforms are another issue. In Michigan and many other states, taxpayers are required to start figuring their state taxes with their adjusted federal gross income and go from there, which could lead to a bump in local tax collections. That's because the federal number is likely to be higher now given the new limitations and restrictions placed on deductions on the federal side.

Another factor is the Supreme Court's Janus decision. The high court ruled that public sector unions can no longer force nonmembers to pay dues, potentially weakening the bargaining position of police, firefighters, teachers and other municipal workers, according to Robinson.

"The Supreme Court ruling is huge for the muni market," Robinson says. "State and local government employees have compensation packages 40 percent higher than the private sector."

Meanwhile, Warren Ward, a certified financial planner with WWA Planning and Investments in Columbus, Ind., sees buying opportunities in the next few weeks as activity in the closed-end muni bond sector stabilizes for a bit.

He contends smaller players like his firm are better positioned to capture bargains on closed-end muni funds since he is placing $100,000 to $200,000 at a time instead of millions.

"The advantage of individual investors is we can always find something we like," Warren said. However, "more people are looking at these so the bargains are not as available."