Stock market volatility is not the top item on the list of things municipal bond investors worry about.

Anyone invested in municipal bonds through closed-end funds, though, might want to start paying attention.

The stock market has been a little more turbulent lately, and whether it makes sense or not, that turbulence can hurt the value of muni closed-end funds.

The Chicago Board Options Exchange’s volatility index, known as the VIX, leaped to 28 last month, the highest reading since November and a level only occasionally breached before the Lehman Brothers bankruptcy.

This has little impact on budget deficits, credit spreads, tax-exempt ratios to taxable bonds, or any of the other things municipal bond investors think about.

It is of great concern, though, to anyone owning a closed-end fund — even a CEF stocked exclusively with high-grade municipal bonds.

In his monthly report, Alex Reiss, a closed-end fund analyst with Stifel Nicolaus & Co., noted a strong correlation between the VIX and closed-end funds, even municipal funds.

Closed-end funds are investment vehicles that raise money by selling ownership in themselves to shareholders and invest the proceeds in an asset such as stocks or municipal bonds.

Because the shares cannot be redeemed, they trade publicly at whatever the market will bear. This often means the shares trade at a premium or a discount to the value of the assets they represent.

Reiss cautioned investors not to think of municipal CEFs as baskets of municipal bonds that behave exactly like baskets of munis . They are stocks, and are subject to the whims, follies, and foibles of the stock market, he said.

The underlying assets only determine part of the return on a closed-end fund in any given period.

Much of it is whether the shares trade higher or lower than the value of those assets, which is purely a function of market sentiment.

For this reason, Reiss said municipal closed-end funds can be just as volatile as stocks.

“Although most of the analysis of municipal closed-end funds is conducted in the language of fixed income, the actual shares of all closed-end funds are stocks,” he said.

“They are heavily influenced by factors such as volume, liquidity, and investor sentiment. While we believe that net-asset-value performance will govern the long-term performance of common shares of a fund, investors should expect equity-like volatility.”

Reiss pointed out that discounts on closed-end funds often widen when the VIX increases.

This was certainly true during the credit crisis, when both the VIX and closed-end fund discounts spiked to once-unthinkable levels.

In fact, municipal closed-end fund performance in both 2008 and 2009 was dominated more by sentiment in the stock market than by the performance of the underlying municipal bonds.

As the chart on this page shows, muni CEFs did much worse than municipal bonds in 2008, and much better than municipal bonds in 2009.

A First Trust Advisors index tracking returns on municipal closed-end funds tumbled 22% in 2008. The S&P National AMT-Free Municipal Bond Index sank just 3% — explaining little of the decline in closed-end funds.

Conversely, municipal closed-end funds surged 43% in 2009. The 12% jump in the Standard & Poor’s municipal bond index did not even explain a third of this rally.

Nobody would argue the VIX was the only variable influencing closed-end funds the last two years.

However, in both the dramatic sell-off of 2008 and the heady returns of 2009, the principal factor was not how the municipal bonds were doing. It was how willing investors were to own the stocks.

The incline in the VIX evidently has not hurt muni CEFs yet. The municipal closed-end fund index leaped 2.2% in January and has not had a bad month since October.

The average discount on municipal closed-end funds is 1.77%, according to Thomas J. Herzfeld Advisors.

Cecilia Gondor, executive vice president at Herzfeld, called this discount “very narrow.”

Herzfeld’s position in munis remains modest, with most of its $426,400 municipal portfolio still in cash.

“There’s just not a lot of bargains in munis,” Gondor said. “We’re not really adding.”

In his review for the fourth quarter, First Trust analyst Jeff Margolin cautioned investors to lower their expectations.

Much of the gains last year stemmed from the narrowing of double-digit discounts — meaning investors paying more per dollar of assets.

With discounts narrow, that type of appreciation in excess of the appreciation in underlying assets is unlikely, he said.

“At the beginning of 2009, closed-end fund investors could have bought funds in every category across the board and they would have made money,” Margolin said. “I do not believe it will be that easy in 2010 and closed-end fund investors need to be pickier and focus on funds where the underlying asset class remains compelling.”

Some municipal funds qualify as compelling, he said.

Many municipal funds offer “very high and attractive dividends,” he said. Further, many funds are out-earning their dividends.

Funds whose income outpace their dividends frequently raise their payouts, as most municipal closed-end funds did last year, often multiple times.

As candidates for funds likely to raise dividends, Margolin looks for funds that out-earn their dividends by 10% and have a month or more of income they have yet to distribute.

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