Bright Spot for Leverage - Increasing Yield, Narrowing Discounts In Levered Municipal Bond Funds

The multi-billion dollar headache caused by auction rate preferred securities (ARPs) is providing a bright spot for levered closed-end municipal bond funds. While the closed-end fund ARP market has left its investors frustrated with illiquid securities paying low interest rates, it has been beneficial to the common shareholders of the closed-end fund. With funding costs so low, levered municipal closed-end bond funds have been able to enhance their earnings, build their undistributed net investment income balance (cash reserve), boost dividends, and ultimately continue to narrow their discounts to NAV.

While levered municipal bonds are traditionally viewed as a safe haven in deteriorating economic times, they were not immune over the past eight months. The unusual volatility in the underlying bonds was amplified in funds that utilized leverage. This caused the discounts of levered municipal bond funds to trade at wider discounts than their unlevered counterparts. We believe this is about to change. Here’s why:

• Borrowing rates for outstanding auction rate preferreds are currently less than 1% in most cases. These low funding costs boost the effects of the carry trade and allow for levered funds to increase their distributions. We have already seen numerous examples of dividend increases, and based on earning fundamentals across the board, expect it to continue.

• Historically, in declining or low short-term interest rate environments, levered municipal bond funds trade on par with or closer to their net asset values (NAV) than unlevered municipal funds. We expect the wide relative spread (currently 6.5%) between unleveraged and leveraged national municipal bond funds to dissipate and reverse in the near to mid term.

• Tepid investor confidence is returning. One prime example of this includes two successful closed-end municipal bond IPO’s and an equity market well off its lows. Numerous filings are in the pipeline for additional municipal bond closed-end funds. This bodes well for funds trading in the secondary market as older funds generally improve before significant new issue funds can come to market. Expect fund companies to help support this sector though increased marketing and greater transparency.

• We expect investors’ appetite for yield will soon return following frustration in low yielding open-end and money market funds. Levered municipal bond funds offer substantial yield benefits while investing in a traditionally less volatile asset class.

• Tax equivalent yields on levered municipal bond funds are near or surpassing much riskier fixed-income yields. The average current yield on a levered municipal fund is 6.7%, assuming a 35% tax rate, is over 10% on a tax-equivalent basis.

• We note discounts remain cheaper now, in an advantageous yield curve environment, than during disadvantageous times such as periods of rising short term rates. We believe as volatility in municipal bonds calms, discounts will revert to levels closer to levels consistent with the interest rate environment historically.

• We expect credit, headline, and supply risk will allow for better short term buying opportunities than current levels in the near and mid-term. We also acknowledge that municipal yields relative to treasuries may not return to their longer term historical averages for some time. Regardless, improving market stability relative to 2008 should provide confidence for opportunistic investors to return and drive discounts tighter over the course of 2009.

Comments

[j'adoube:]

That last bullet point seems like a cop-out. You spend the rest of the article relating what a compelling opportunity levered muni CEFs are, then in the last bullet point you take it away, saying there will be a better entry point than this.

Guys, make up your minds, and take a stand. If now is not the time, why don't you publish this article when it IS the time?

Apr 21 12:53 PM

[Relative Va...:]

j'adoube- Since we were not attempting to identify a trading opportunity, but rather a theme in a specific market, we thought it would be appropriate to identify the risks we see in our thoughts and observations. And while we like and own specific funds within this fund segment, we do believe there will be better buying opportunities going forward. Thanks for your comments!


On Apr 21 12:53 PM j'adoube wrote:

> That last bullet point seems like a cop-out. You spend the rest of
> the article relating what a compelling opportunity levered muni CEFs
> are, then in the last bullet point you take it away, saying there
> will be a better entry point than this.
>
> Guys, make up your minds, and take a stand. If now is not the time,
> why don't you publish this article when it IS the time?

Apr 21 02:44 PM

[Gruber:]

While current interest rates on ARPs are low due to prospetus covenants relating to a low default rate on unsuccessful auctions, isn't this a temporary phenomenon? It seems CEFs are anxious to pay-off the ARPs and such refinancings is likely to boost leverage expense above the current low default interest rate. Wouldn't this likely result in a deminished future distribution?

Gruber

Apr 26 11:34 PM