Recently municipal bond closed-end funds were trading at outlandish discounts compared to their historical norms. While the discounts have narrowed, the funds largely remain available for purchase at less than net asset value and they offer attractive taxable equivalent returns. But - do you really understand the risks you're taking.
Most closed-end funds expose investors to some degree of credit risk, its unavoidable for anything other than a US Treasury. The degree of credit risk varies widely. Many concentrate their portfolios in highly rated issuers backed collateral and/or insured against default. At the other end of the spectrum are obligations issued by less credit worthy issuers and are mere general obligations. Closed-end fund investors can get a reasonable view of credit quality by viewing the portion of the portfolio invested rating.
Many closed end funds seek to enhance returns by employing leverage or borrowing funds. (or issuing preferred shares) The borrowed funds are invested in additional municipal bonds targeting higher yields than the borrowing cost. The excess interest and return is paid to the fund's investors typically resulting in a higher distribution yield than the equivalent unleveraged portfolio yield. The enhanced return comes at a risk to fund investors as any changes in portfolio value are borne entirely, at first, by the fund investors. For example, a portfolio that has assets of 130% of its Net Asset Value (NAV) may have a drop in value of 1% of the portfolio assets that would result in a 1.3% decline for the fund's investors. Further, as the borrowing costs rise the excess return will be reduced, if the portfolio yield does not rise by an equal amount. Investors would likely see a reduced distribution yield, or in some cases, more of their distributions funded as a return of capital.
The most appreciated risk by fixed income fund investors is interest rate risk. Municipal bonds are no different than other fixed coupon investments in that as rates risk the value of longer dated fixed income portfolio's will decline and vice versa. Many closed-end municipal funds may exacerbate the risk through leverage as described above and the purchase of callable bonds.
Callable bonds allow the issuer to repurchase the bond at a future point in time if rates decline, whereby they can presumably reissue the bond at a lower interest rate and cost to them. Should rates increase the issuer will continue paying interest, at presumably a below market cost. This creates a heads issuer wins tails bondholder loses scenario - often referred to as an option. To compensate municipal bondholders for the retaining this benefit, or option, typically issuers must pay a higher coupon (or yield) for the callable versus non-callable bond.
To evaluate the overall interest rate risk in the municipal closed-end fund portfolio managers will report the duration, both with and without leverage. This metric provides investors with a measure of their interest rate sensitivity.
Below we have cited several measures from Nuveen Municipal Opportunity Fund. (NIO) From the below fund investor's can determine their interest rate sensitivity excluding leverage is 10.76 and 16.06 with leverage. The same or similar details can be found for most closed-end funds, including the largest such as Nuveen Municipal Value (NUV), Blackrock Muni Term Target (BTT) and Nuveen Municipal AMT Tax Free. (NEA)
From the Wall Street Journal (WSJ) Ryan Index investors can compare their funds interest rate sensitivity to US Treasury Obligations. Using the below for the NIO Fund the interest rate sensitivity of 16.06 is very close to the 30 Year Treasury with a modified duration of 17.737. Thus meaning the portfolios change in value to interest rates will be only modestly less than the 30 Year.
Municipal Bonds, in particular closed-end funds, offer investors an attractive means to realize tax advantaged yields. However, it is important in a well-diversified fixed income portfolio that investors fully understand the risk profile including incremental credit, leverage, and effective interest rate risk of the portfolio. In some cases it may be appropriate to take measures to offset or reduce the interest rate risk given the composition an investors portfolio.
As of 12/31/2013
# of Holdings
% Portfolio Pre-refunded *
% AMT * (As of 10/31/2013)
Avg. Coupon *
Effective Duration *
Leverage-Adjusted Effective Duration *
Effective Maturity *
Avg. Bond Price *
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3 Month Treasury
6 Month Treasury
1 Year Treasury
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