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Anatomy of a Closed-End Muni Fund


How, and more importantly, why are leveraged closed-end muni funds created and structured?

About 15 years ago, Nuveen and others like Merrill, Blackrock and Putnam began offering 'leveraged closed-end muni funds'. I would like to take this opportunity to explain how and more importantly, why they are created/structured.

Note: As a reference, check out my four part Bond Basics Tutorial: Part 1, Part 2, Part 3, Part 4.

If you were to go out and buy a long term municipal bond right now, it would fetch about 4.85-4.90%. And if you were to buy a closed end levered muni fund, you get about, well...4.90%. So why would anyone buy something that is essentially a municipal bond portfolio on margin? After all, the way these deals are structured is as follows: They 'borrow short and lend long' --in other words, they fund their leverage via money market (short term) floating rate preferred shares that are actually backed by the bonds in the portfolio. So let's say you borrow at 3.5% and lend at 5% and, voila! You capture the spread.

Enter the brokerage firms. When these funds are brought to market, they are typically offered at $15 per share but come with a hefty sales charge and fee of 7%! Yep, you get $13.95 worth of bonds for $15. A bargain? I think not. But in the new deflationary days of trading bonds or stocks, it amounts to what we might call a 'seven point rocket.' Pretty appealing for the brokerage community. Eventually, the market smells this out and the securities often settle at a discount to net asset value, sometimes as much as 15%. This takes the $15 to $13.95 to $11.85. Take a look at this chart of Investment Grade Municipal Income Fund (PPM) and you can see what I mean by the discount to NAV.

Why is this done? To generate the 7% commission and an annual management fee that generally hovers around 1%. Check out the table below of the fee structure…1.39% a year…yeesh!

And this business is being sold for 26x? You must be kidding me.

As far as these funds go, I play them from both the short and long side but very carefully and I generally look for non leveraged funds like NXR and NXQ if I want exposure. but to be frank, they are usually not liquid enough for me.

But all I can say is, buyer beware! Oh yeah, one last thing. They have all been cutting their dividends of late, partly due to the flattish yield curve and partly because the high coupon bonds they bought in the past are being called and they have to replace with lower coupons as you can see in MYI here...

Yep, that's right sports fans, a five year compounded growth rate of minus 6.22%. I rest my case.
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