Closed-End Funds Avoid Customary Year-End Sell-Off

As if municipal bond closed-end funds needed any more help, the year-end tax selling that customarily plagues the industry every December took the year off in 2009.

Municipal closed-end funds provided a 1.1% return in December, according to a First Trust Advisors index tracking the sector. That brings total returns for the year to a hearty 33.9%, partially recouping last year’s 30.5% free fall.

December is traditionally a cruel month for closed-end funds. Investors looking to shield income from taxes usually sell CEFs for tax purposes. Municipal closed-end funds suffered losses of 1.09%, 0.17%, and 0.08% in the final month of 2008, 2007, and 2006, respectively.

It did not happen in 2009.

Normally, tax-conscious investors toward the end of the year sell CEFs at a lower price than they bought them for. That sale locks in a capital loss. The loss offsets other taxable income.

Investors can only save on taxes by selling a closed-end fund if they sell the fund at a loss.

The asset did so well in 2009 that it was hard to find funds trading at lower prices.

After a disastrous 2008, everything went right for muni CEFs in 2009. Cheap leverage, a steep yield curve, electrified investor demand, and a terrific year for municipal bonds fueled a historic year for the sector.

“Just as virtually nothing worked in 2008, virtually everything worked in 2009,” Alex Reiss, a closed-end fund analyst with Stifel, Nicolaus & Co., wrote in a report yesterday. “The closed-end fund universe has had a remarkable year.”

Muni closed-end funds are vehicles that sell shares in themselves to investors through an initial public offering and invest the proceeds in municipal bonds. The industry’s roughly 260 funds managed $80 billion in municipal bonds at the end of the third quarter, according to the Investment Company Institute.

The sector’s rebound last year had three-pronged support.

First, the municipal bonds the funds invest in delivered healthy gains. The Standard & Poor’s AMT-Free National Municipal Bond Index jumped 12.2% last year.

Returns on CEFs, though, far outpaced the increase in the value of the assets they invest in, largely due to two factors.

One is leverage. Closed-end funds often supplement the money they raise from investors in an IPO by borrowing additional money, such as through the sale of auction-rate preferred shares.

Whatever a closed-end fund collects on its municipal bonds in excess of what it pays on its ARPS results in extra dividends for shareholders.

The interest rate closed-end funds pay on ARPS is often tied to a short-term interest rate benchmark such as the London Interbank Offered Rate. With the Federal Reserve committed to keeping short-term interest rates pinned to zero, benchmarks such as Libor, and consequently closed-end funds’ borrowing costs, are minute.

The three-month Libor rate ended 2009 at 0.25%, according to Bloomberg LP.

In other words, CEFs are buying extra municipal bonds and collecting extra coupon payments on those munis at minimal cost.

Consider the Nuveen Insured Municipal Opportunity Fund, the biggest leveraged closed-end municipal fund.

The fund owns 391 municipal bonds valued at $2.04 billion. Of this, $675.5 million was purchased with money borrowed through ARPS. The remaining $1.36 billion are “common” assets, or assets shareholders are entitled to.

The municipal bonds in the fund’s portfolio pay an average coupon of 4.81%. The fund only pays 0.3% on its ARPS.

So the fund’s shareholders earn the interest on the $1.36 billion of municipal bonds counted as common assets, plus the spread of the interest on the $675.5 million in munis over what it pays on its debt.

Thus, leverage provides a portfolio with an average coupon of 4.81% an annual dividend of 5.6%.

The steepening of the yield curve aided by a collapse in short-term rates helped amplify closed-end funds’ leverage in 2009.

The last factor buttressing the industry in 2009 was narrowing discounts, which means investors were willing to pay more per dollar of fund assets.

Because CEF shares cannot be redeemed for the value of a fund’s assets, a fund’s share price is often unmoored from its asset value.

Consider again the Nuveen Insured Municipal Opportunity Fund. This time last year, its assets were valued at about $12.50 per share. Its shares traded at about $11 — a discount of 12%.

Since then, the value of its assets has increased 15%. The value of its shares has increased 22%. The discount is now 6.6%.

The discount has narrowed — investors are paying more per dollar of assets.

Sangeeta Marfatia, a closed-end fund analyst with UBS Wealth Management, said discounts on national leveraged municipal CEFs have contracted to 2% on average from 10% at the beginning of last year.

Marfatia said these gains were likely exhausted in 2009. Anyone buying a municipal closed-end fund now should be banking on the dividends, not further appreciation in the shares, she said.

Dividends alone might not be enough, though.

The hefty dividends that attracted investors throughout 2009 should be placed into context, Thomas J. Herzfeld Advisors wrote in its report for December.

Investors should be wary of buying a closed-end fund that is trading at a premium, even if the dividend is enticing, according to Herzfeld.

“When purchased at an excessive premium, funds have limited upside price potential, and have much further to fall if payouts are cut,” the Miami-based firm wrote.

That said, Herzfeld Advisors is doing something it has not done in months: buying municipal closed-end funds.

The company’s $424,000 muni CEF portfolio was left entirely in cash for November and December, and has only had light positions in funds since the spring.

Now the fund is 38.2% invested, the longest position since May. The firm owns the $335.5 million Eaton Vance National Municipal Opportunities Trust, which trades at an 8% discount.

Herzfeld also owns three Nuveen funds devoted to buying Michigan bonds, and a Morgan Stanley fund dedicated to California.

The firm also has five unqualified buy recommendations on municipal closed-end funds, for the first time in months.


Upcoming Events

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