Closed End Muni Bond Funds

The second half of the Current Yield (subscription requires) column in this week's Barron's was about Muni CEF's that use leverage and have very high yields.

There are many of this type of fund from many different providers.

The funds leverage up by borrowing at short term rates and buying more bonds. Problems occur when rate go up. These funds can get crushed in a rising rate environment (this is true of all closed end income funds not just muni funds). Take a look at the chart for any CEF income fund in June and July of 2003 to see how volatile they can be. The issue is that most people buy these CEFs for income. It can be very stressful when your income producing portfolio takes a 15% or 20% hit in few weeks.

The article quoted an analyst named Mariana Bush from Wachovia as saying you may not want to sell these funds in the face of continuing rate hikes and the threat of the market taking up the rest of the curve. She says it would be difficult to replace the income.

That maybe so but it makes sense to consider actively managing this type of portfolio so you don't get badly hurt. A way to do this is to own a fund or two that has a short duration (there are several of these). Duration refers to the average date that the bonds mature or can be called. Another tool available is an open end fund that shorts the bond market, an inverse bond fund. They go up in price when yields go up. There are three that I know of and I use one of them for some of my clients. Another alternative is one of those floating rate funds. Proponents of these funds say that the dividend go up when rates rise, making them less interest rate sensitive. I have written before that I am not of fan of these. An investor in them is relying on the market to get it right about the interest sensitivity. Also they have poor credit quality and low yields.

It would have been nice if the article addressed some of these issues in more depth. I don't think most people realize how hard these funds can get hit. They tend to come back but I can see people getting shaken out at a low.

The article also referred readers to a favorite site of this blog, ETFConnect, for more info on CEFs.