Buy Side

Closed-End Funds Back With a Vengeance

Closed-end municipal bond funds have come screaming back to life as the confluence of cheap financing costs and hearty long-term rates has bolstered dividends and lured investors to tax-equivalent yields of often 10% or more.

Closed-end muni funds are the most valuable they have been since the Lehman Brothers bankruptcy and have delivered 37% returns in 2009, according to a new First Trust Advisors LP index tracking total returns in the sector.

Cecilia Gondor, executive vice president of Thomas J. Herzfeld Advisors, said the slope of the yield curve and the leverage structure most funds employ have created an ideal climate for the 260-fund, $73 billion industry.

Closed-end municipal funds are created through an initial public offering, which entails selling shares in a fund to investors and supplementing the cash raised in the IPO with short-term borrowing meant to amplify returns.

The fund invests the cash collected from investors and the borrowed money in municipals.

Unlike a unit investment trust or an open-end mutual fund, investors cannot redeem closed-end fund shares at net asset value. The shares trade on a stock exchange at whatever the market will bear.

Because shares trade based on supply and demand rather than net asset value, and because the short-term borrowing introduces leverage, municipal closed-end funds usually trade at a premium or discount to net asset value — more often a discount.

During the worst of the credit crisis last year and early this year, like almost every asset class, muni closed-end funds were victims of panicked selling and illiquidity.

The discount to NAV on municipal closed-end funds went from an average of 6.3% in August 2008 to 11.4% in September, and peaked at 26.1% on Oct. 10, according to data from Thomas J. Herzfeld.

The discount has steadily come down all year, and is currently just 2.1%. Since the beginning of the decade, closed-end municipal funds have usually traded at a discount of at least 4%.

For national muni closed-end funds, the discount is only 1%, compared with an average discount of 6.1% over the past year, according to Richmond, Va.-based Closed-End Fund Advisors.

Gondor ascribes the bounceback to two factors, essentially opposite ends of the same yield curve.

One, closed-end funds are borrowing money for next to nothing.

The source of borrowing for a municipal closed-end fund is typically auction-rate securities or tender-option bonds.

An ARS is long-term debt that is designed to behave like a short-term security because its interest rate resets at an auction regularly.

The twist comes if nobody bids at the auction, which began to happen regularly after February 2008. In that case, the holder is stuck with the security and the issuer is forced to pay a penalty rate.

Most of the ARS issued by municipal closed-end funds reset to “penalty” rates tied to a short-term benchmark such as the London Interbank Offered Rate.

With these short-term rates flirting with zero, municipal closed-end funds are borrowing money for fractions of a percentage point.

Nuveen Investments, which runs more than 100 municipal closed-end funds, publishes the rates it pays on the ARS used to leverage the funds.

That rate today: 0.47%.

“They’re called penalty rates, but in effect since they’re based on indexes, what we’ve seen is they’re not punitive at all,” Gondor said. “It’s almost like free money, and then you go and invest it long term.”

Which brings us to the other boon to closed-end funds: fat rates on the long end.

The steep yield curve means many closed-end funds are earning a hefty spread between what they pay on short-term financing and what they collect on long-term munis.

The result is plump monthly dividends that have attracted interest from investors more confident about the economy, Gondor said.

Most closed-end municipal funds have raised their dividends.

Alex Reiss, a closed-end fund analyst with Stifel Nicolaus, said of the 41 muni funds he covers, 38 have boosted payouts this year.

BlackRock and Nuveen earlier this month hiked the dividends on a slew of their municipal closed-end funds, some not for the first time this year.

Of BlackRock’s 28 national municipal closed-end funds, 17 sport taxable-equivalent dividend yields north of 10%, assuming a tax rate of 35%.

Six of Nuveen’s 28 national funds boast taxable-equivalent yields topping 10%, including one exceeding 13%.

Reiss said he expects funds to continue raising their payouts because they are earning more than they are paying in dividends.

This is measured by undistributed net-investment income, or the UNII balance, which describes income not yet paid out to shareholders.

Reiss has “buy” ratings on several national municipal funds with heavy UNII balances, including Van Kampen Advantage Municipal Income Trust II, which has almost 21 cents per share in undistributed income.

He also likes the Nuveen Insured Municipal Opportunity Fund, BlackRock MuniYield Insured Fund, and Morgan Stanley Quality Municipal Securities, among others.

Investors have noticed the magnifying benefits of cheap leverage and have been buying, according to Gondor.

The First Trust index tracking returns on municipal closed-end funds is up 9.4% in the last two months.

“Performance for almost every fund has been on the upswing so investors are happy,” Herzfeld Advisors wrote in its latest monthly report. “In fact, our only complaint is that there are few funds worth buying.”

More than 100 funds traded at a premium to NAV at some point last month, according to Herzfeld.

Herzfeld Advisors does not have a single unqualified “buy” recommendation in the universe of municipal closed-end funds.

The firm has a $424,000 portfolio devoted to municipal closed-end funds — 92% of which is sitting in cash.

“We don’t see any reason to pay more than NAV,” Gondor said. “We’re waiting for an opportunity to buy when the discounts widen.”

If a closed-end fund is at a premium, investors should opt for an exchange-traded fund or a mutual fund, said John Cole Scott, a portfolio manager at Closed-End Fund Advisors.

In a report this week, Bank of America-Merrill Lynch closed-end fund analyst Jon Maier advised selectivity because of the narrowing discounts.

He worries the sector’s strong performance this year “may induce profit-taking in the near to intermediate term.”


Upcoming Events

Already a subscriber? Log in here
Please note you must now log in with your email address and password.