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Herb Morgan (Efficient Market Advisors, LLC) submits: Many of those desirous of tax exempt income are current owners of leveraged closed-end municipal bond funds. These funds come fully equipped with all the risks of leverage. Unfortunately, many of the owners of these vehicles are completely unaware of the hazard that may await them.

While traditional bond funds carry interest rate risk and are naturally inclined to price depreciation as rates rise, leveraged funds carry a double edged sword of risk. The first is the risk of an inverted yield curve and the second risk of inadequate liquidity. In the event of an inverted yield curve investors may find themselves without a dividend and may be pressured by sales people to monetize what would likely be a temporary loss.

When determining a fund's sensitivity to movements in interest rates one should consider its duration. Durations of less than four years are considered minimal, while durations of more than eight years are considered very sensitive to interest rates. Taking a fund with a hypothetical duration of eight years and adding 35% leverage exposes an investor to a duration of 12.3 years. In a February 2004 report, Wachovia Securities Analyst Mariana Bush states,

If interest rates were to rise by 100 basis points or 1%, a 12.3-yer duration would result in a decline in the fund’s net asset value of 12.3% -- over 50% greater than what the un-leveraged duration may anticipate.

Closed-end municipal funds obtain their leverage by issuing preferred shares whose dividend is tied to short term interest rates. Proceeds of the issuance of all shares are invested in long term bonds. Since long term bonds historically pay higher rates than short term bonds, the interest left after paying the short term preferred dividends is used to enhance the yield to the common shareholder. However, if short term rates were to exceed long term rates (an inverted yield curve) then a clear and present danger of dividend cut or omission exists for common shareholders. I am not predicting an inverted yield curve nor do I think it would be prudent to do so; however the possibility exists as Friday’s two year Treasury yield of 3.88% was only 25 basis points below the yield of the ten year Treasury at 4.13%. Crazier things have happened.

If the previous scenario were to unfold I suspect that many closed-end fund investors would either panic on their own volition or be talked into panic by frenzied retail stockbrokers looking to cash in on the turbulence of the markets. Looking at my own state of California, most of these vehicles have average trading of well less than 30,000 shares per day. This limited liquidity could cause severe price depression in the event of high selling volume. Of course inverted yield curves when they happen are usually temporary so the opportunity exists for the savvy trader to take advantage of the sell-off should it occur.

In conclusion the best course of action for owners of leveraged closed end municipal bond funds is to either take some profits now or be prepared to ride out the storm should the worst happen in the markets. The worst course of action would be to sell during a period of inversion and dividend omission.

Source: Clear and Present Danger for Owners of Leveraged Closed-End Muni Funds