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Will Muni Bond Fears Get Worse?


We are probably moving into an ongoing rising interest rate environment, which will continue to put downward pressure on virtually all bond prices.

It's not only tough from an emotional perspective to see one of our great cities, Detroit, go bankrupt, but the disaster has also caused a lot of pain in the municipal bond market where investors are selling on fears that other cities around the country will follow suit.

But putting sympathies for Motor City aside, there may be a trade in this situation for intrepid investors.

All the fears about municipal bond defaults have closed-end municipal bond funds trading at steep discounts. That makes many of them potential buys on the assumption that all the fears ease to some degree over the next several weeks or months.

"The recent pressure on share prices is presenting an opportunity to buy some well-managed funds at attractive discounts," says Cecilia Gondor at Thomas J. Herzfeld Advisors, which specializes in closed-end funds. "We like muni funds as short-term trades."

Meanwhile, you also stand a chance to get a 5%-6% annualized tax-free yield if you hold them long enough (they typically pay out monthly).

Closed-end funds are similar to mutual funds except for the fact that they raise investment capital in one-off shots, as opposed to getting fresh money (or redemptions) daily from investors, and their shares trade throughout the day.

Let's be clear: Discounted closed-end municipal bond funds may only be a short-term trade on a near-term reduction in fears about municipal defaults. The reason: We are probably moving into an ongoing rising interest rate environment here, which will continue to put downward pressure on virtually all bond prices.

In the interim, though, meaning over the next several weeks or months, fears about municipal bonds could ease enough to make these closed-end funds rebound nicely.

"Closed-end fund investors tend to overreact to disasters, so share prices decline more quickly than underlying net asset values," says Gondor. Net asset value (NAV) is the actual value of the underlying holdings in the fund. The "discount" refers to the difference between the market cap of the closed-end fund, and the NAV. "This inefficiency provides attractive investment opportunities when the discount become unusually wide. As things calm down, net asset values typically stabilize or recover and discount levels narrow."

Here's a list of the best potential trading vehicles in the municipal bond closed-end fund space, according to Gondor. The first two percentages following the fund name are the average fund discount to NAV over the past year, and the current discount to NAV, respectively. Looking for the widest gap between the historic discount (the first percentage) and the current discount (the second percentage) leads you to the better potential trades, as opposed to just buying funds with big discounts. The reason: Closed-end funds often trade at a discount to NAV, so it's the size of the discount compared to a fund's historic discount that matters. The third percentage after the fund name is the annualized yield. All percentages are as of the close of trading August 12.
  • Nuveen Dividend Advantage Municipal Income Fund (NYSEMKT:NVG) -6.6%; -13.8%; 5.33%
  • Nuveen Dividend Advantage Municipal Fund 3 (NYSEMKT:NZF) -6.2%; -13.8%; 5.73%
  • Nuveen Quality Income Municipal Fund (NYSE:NQU) -5.2%; -12.1%; 6.33%
  • Delaware Investments National Municipal Income Fund (NYSEMKT:VFL) -5.6%; -12.1%; 6.16%
  • BlackRock Municipal Income Investment Quality Trust (NYSE:BAF) -3.4%; -11.6%; 6.54%

All of these funds are leveraged, which means managers have borrowed money to invest. That should give these funds extra spring in any rebound caused by a reduction in fears about muni bond defaults. It also means that these funds would fall more than unleveraged funds, if fears get worse. In short, leveraged funds are more volatile.

Will the fears about muni bonds get worse? No one knows for sure. But I'm going to guess that while a lot of cities have trouble with budgets that are out of balance, given all their borrowing and all the pension promises to city employees, we might not see another major Detroit style announcement any time soon.

One possible turning point to watch involves a pending court decision in Michigan on Detroit, where pensioners and municipal bond investors are fighting over who should take more losses in the bankruptcy reorganization. If the decision favors pensioners, "expect to see some broad fallout in the municipal market, even for financially strong cities and states," says Fred Dickson a market strategist with the brokerage D.A. Davidson & Co.

Michael Brush is an award-winning New York-based financial journalist who writes a weekly stock market column for MSN Money and is the editor of Brush Up on Stocks, an investment newsletter. Michael has covered business and investing for the New York Times, the Economist Group, and Money magazine. He studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of Lessons From the Front Line, a book offering insights on investing and the markets based on the experiences of professional money managers.
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