Reality has set in for municipal closed-end funds. And reality is not so bad.

Most analysts who cover the industry agree the party is over. Investors next year should not expect the 34% returns municipal closed-end funds have delivered so far this year, they say.

However, closed-end funds may still be worth buying because they offer meaty dividends at a time when such income is hard to find.

“There are no alternatives for income in this environment,” said Sangeeta Marfatia, a closed-end fund analyst with UBS Wealth Management. “People buy closed-end funds for the income.”

Municipal CEFs are trusts that raise money by selling shares, representing ownership interests in the trusts, to investors. The funds take the cash and buy municipal bonds. The shares trade publicly and are entitled to the gains earned by the trust.

The muni CEF industry’s 260 funds manage about $80 billion, according to the Investment Company Institute and the Closed End-Fund Association.

There are three sources of returns on closed-end funds: dividends, appreciation in the value of the assets in the trust, and investors in the stock market willing to pay more per dollar value of assets in the trust.

Much of the returns this year have come from the third source.

Because closed-end funds trade publicly, the share values often fluctuate around the asset values. When a discount narrows, it means each dollar of closed-end fund assets commands more now than it did before.

That is what fueled the rally this year. The average municipal CEF at the beginning of this year traded at a 12.4% discount to the value of its assets, according to Stifel Nicolaus analyst Alex ­Reiss. That discount has shriveled to 3.2%.

Reiss wrote in a report last week not to expect that to repeat in 2010. The current discount is already narrower than its historical average and it is not likely to narrow further.

The appeal of a municipal closed-end fund now is its dividend, he said.

“The performance boost experienced by these funds due to closing discounts is not likely to be repeated this year,” Reiss said. “Income, not capital gains, will have the greatest effect on the funds’ total returns going forward.”

So what makes closed-end fund dividends so special?

CEFs distinguish themselves from mutual funds, exchange-traded funds, unit investment trusts, or municipal bonds themselves because of a unique ability to employ leverage.

Many muni closed-end funds borrow money supplementing the cash raised from investors.

They invest the borrowed money in municipals, too, and the spread of what they collect on the municipals over what they pay on their debt is extra dividends for shareholders.

With the Federal Reserve committed to keeping borrowing costs low, closed-end funds are benefiting from an enormous spread on what they are collecting on their bonds over what they are paying on their debt.

Take, for example, Nuveen Investment’s Premium Municipal Income Fund. The fund manages $1.28 billion, of which $400.7 million is borrowed through the sale of auction-rate preferred shares, or ARPS.

The fund owns 322 municipal issues with an average rating of double-A and an average maturity of 17 years. The average annual coupon on its bonds is 4.95%

Normally a shareowner could not expect to collect much more in dividends than its fund collects in coupon payments.

However, the fund pays a rate of only 0.44% on its $400.7 million of ARPS debt, meaning most of the coupon payments are left over as gravy for shareholders. In other words, the fund is paying nearly 100% of its earnings to shareholders who own less than 70% of the fund’s assets.

The result is the fund’s most recent monthly dividend annualizes to a 6.4% yield.

Nuveen is the biggest municipal closed-end fund manager with more than 100 funds totaling $33.7 billion.

The company’s 21 leveraged national funds all offer tax-exempt annualized dividend yields of at least 6%, and a few yield more than 8%.

Van Kampen runs five national leveraged closed-end municipal funds, some of which enjoy borrowing costs as low as 0.17%.

All five of the Van Kampen leveraged national funds, with a total of $2.36 billion in assets, offer tax-exempt annualized yields north of 7%.

This comes at a time when, according to Municipal Market Data, an A-rated 10-year muni yields 3.8%, most of the biggest municipal bond mutual funds yield less than 5%, money market funds yield next to nothing, and the State Street exchange-traded fund tracking the Standard & Poor’s 500 Index yields less than 2%.

Most Nuveen muni funds raised their dividends last month. So did many funds run by Van Kampen, Morgan Stanley, and Eaton Vance.

While UBS’ Marfatia would not be surprised to see a pullback in prices of closed-end funds, she considers the dividends safe.

The municipal funds she covers are limited to investment-grade bonds, which she does not worry about because of their stellar credit quality.

The only immediate threat facing the funds’ dividends is a spike in short-term interest rates, which Marfatia does not think will happen.

Perhaps short-term rates next year will jump to 0.7% or 0.9% as the Federal Reserve begins to tighten the money supply to head off inflation, she said. Even then, though, funds will enjoy a plump spread to enhance their dividends.

Thomas J. Herzfeld Advisors is still bearish.

The Miami-based closed-end fund shop has been saying for months that discounts in the sector are too narrow and will eventually widen back out.

In many cases, municipal closed-end funds are trading at premiums to their asset values.

Herzfeld, in a report last month, recommended selling these funds “because the odds of making money are against the investor ... not only must the fund perform well, but investors must continue to pay a premium, and perhaps a growing premium, for the investor to come out ahead.”

Herzfeld still has all $423,596 of its portfolio dedicated to muni CEFs in cash. The firm is waiting for wider discounts.

While discounts are still not attractive enough to warrant buying, Herzfeld said they have expanded a bit lately.

Although the company still has no unqualified buy recommendations among municipal closed-end funds, it has a growing number of “buy if” recommendations.

For instance, BlackRock’s MuniHoldings California Insured Fund trades at a roughly 12% discount to the value of its assets. Herzfeld recommends buying if the discount widens to 14%.

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