December 13, 2010
Investors have noticed a steep decline in the prices of closed-end municipal bond funds lately. If you own such funds I strongly recommend that you determine whether your fund employs leverage. In a recently-more-volatile bond market, you may have some decisions to make.
Many closed-end muni funds use leverage. That is, they borrow money to buy more bonds, with the expectation that they can borrow at a lower rate than they can invest, thus earning extra income for the fund. But leverage can cut both ways: you might buy a house for $100,000 with a down payment of $10,000 and a mortgage of $90,000. If you then sell the house for $120,000 and pay back the $90,000 mortgage, the remaining $30,000 represents a tripling of your money on only a 20% increase in the price of the house. Of course, if the price of the house falls 10% to $90,000 your down payment is wiped out: a 100% loss on a 10% drop in price. It works similarly with a leveraged fund.
You can determine if a fund is leveraged by going to the sponsor's website and looking at the portfolio. The simpler way is to ask your advisor. But a quick way to know is to look at the yield. The high end of the NY muni market is about 5%, and a fund will pay less, about 4-4.5%. If you are looking at a muni fund that pays more than that, chances are good that it employs leverage.
IF you hold a leveraged fund for many years and IF the fund maintains its dividends, then you will end up with a market return - decent income that makes up for diminished principal. But if you would like to avoid years of seeing the price languish and the likelihood of dividend cuts, consider moving to a more conservative vehicle: an unleveraged fund or individual bonds. They will earn less income; yes. But your capital will be safer. It is highly unlikely that you will continue to earn 6%+ and get all your capital back. Hasn't happened in the past - won't happen now. The best course is to understand what you have and how it works - we can help with that - and then decide if higher income is worth the (much) higher risk to capital.
(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities).