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One of my readers has asked for my thoughts on the recent selloff in the leveraged muni bond CEF sector last week and whether this is just the usual seasonal widening of the discount.

Why was there such an extreme pullback? Muni CEFs saw both a decrease in their NAV’s along with widening discounts. Here are some reasons for the decrease in NAV values:

1) Lower prices in the overall bond market, especially in the long end of the curve. Because of leverage, the muni CEF funds drop more than the average bond.

2) The Obama administration appears to be abandoning its effort to raise the tax rate from 35% to 39% for the top bracket. Many investors in this tax bracket own municipal bonds, and ironically may have lost more in their bond portfolios than they will save in personal income taxes.

3) Concerns about debt restructuring in Ireland.

4) Media articles about muni defaults in small towns (Vallejo, CA; Central Falls, RI; Harrisburg, PA).

5) Long term issues with rising pension costs.

6) Potential of some state credit rating falling below investment grade (Illinois and California are uncomfortably close to the lower end of investment grade). This could cause forced selling in mutual funds that can only own investment grade debt.

7) Long term munis benefited when supply dwindled due to the introduction of Build America Bonds (BABs). The tax subsidy for BABs is set to expire on Dec. 31. Tax legislation is uncertain on the extension. If the BAB program is not extended, supply of long term munis will increase dramatically, so some people may be selling beforehand.

8) Some investors may be selling to lock in a gain because they think capital gains rates may be higher next year.

9) Many muni bond dealers close their books early and don’t like to add balance sheet risk in November and December. This means less price support.

In spite of the above reasons to sell, I think leveraged muni bond valuations and yields look quite attractive now on a tactical basis.

1) The yields of some high quality AA rated national funds are now over 6.5%, and the average discount has widened to 5% or more from small premiums just two weeks ago.

2) The selloff in Muni CEF prices has been much more severe than the drop in the underlying municipal bonds, even accounting for the leverage. Last week, prices fell about 6%, while NAVs fell less than 2% and the underlying muni bonds less than 1%.

3) Year end special dividends will be announced shortly which could give a boost to these funds. These calculations are based on an October 31 fiscal year, so last week’s NAV drop should not affect the special dividend calculation.

4) In the past, excessive price pullbacks in Muni CEFs have usually provided excellent buy opportunities. A similar selloff occurred last October. Prices fully recovered within four months.

Given the political uncertainty, deteriorating long term finances and the potential of falling credit ratings, muni bond’s reputation for safety and stability will be tested over the next few years. Investors should be more discriminating than usual.

One reason I prefer muni bond CEFS over buying individual muni bonds is that a professional from a top firm (e.g. Nuveen, Pimco etc.) selects your bonds. These pros live, eat and breathe muni bonds all day long, and know about the troubled issuers long in advance. Some of the lower rated muni CEF bond funds are now yielding over 7%, but given the current environment, I prefer funds with an average rating in the AA range with current yields in the 6.5% range.

It looks like the Fed Fund rate will stay low for at least another year, so the highly attractive leverage for the muni bond CEFs should remain for quite awhile. Right now, the tactical opportunity in the muni CEF funds makes them a good buy. There may be even better values next month, so it may make sense to scale in gradually. But to be safe a trailing stop loss should be used based on your risk tolerance, in case long term interest rates unexpectedly start to rise dramatically.

Full disclosure: Long muni bond CEFs in some client accounts. Bought some NAD and NQU on Friday.

Source: Time to Buy Leveraged Muni Bond CEFs?