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Six Halloween-Costume Muni CEFs

These six muni funds are not what they appear to be.

Steven Pikelny, 10/28/2011

October has been a spooky month. At the beginning, investors receiving their retirement and investment statements saw massive declines from the third quarter. Yesterday, the stock market had a massive rally. The market's resulting high volatility is causing many investors to feel as though they are in a horror movie. Municipal closed-end funds, or CEFs, have been a popular safe haven, offering high distribution rates on a historically safe asset class. Over the last month, the average municipal CEF discount has narrowed to 1.8% from 3.8%.

But while many municipal CEFs appear attractive at first glance, some can be deceptive. They wear costumes that hide their real identities, lulling investors into a false sense of security. Some funds are all dressed up as harmless sheep, seemingly offering humungous distribution payments and low-municipal default risk, but under their masks, they are actually wolves. Alternatively, some funds wear unassuming costumes, blending in with the crowd, reflecting the safer nature of their psyches; these are the funds we prefer--nothing scary and they get the job done. To illustrate, let's unmask two funds (one scary and one unassuming) from three states: California, Minnesota, and New York.

PIMCO California Municipal Income II PCK
This California municipal fund offers an incredibly high distribution rate of 9.7% at net asset value. Even after taking account for the fund's monstrous premium of 22.0%, the distribution rate at the current market price of 8.0% is still impressive. For California investors in the highest tax bracket, this is equivalent to a 14.7% distribution rate. While this may sound like a good deal, remember that California is home to the Bates Motel. The fund's seemingly attractive distribution could lure you in, but its leverage might sneak up and kill you while you're in the shower.

PCK is one of the highest leveraged funds in the CEF universe with a total leverage ratio (total assets/net assets) of 1.91. The fund uses preferred shares, tender-option bonds, and reverse repurchase agreements. After accounting for the fund's premium and leverage, we are left with a less spectacular core distribution rate (distribution rate/leverage ratio) of 4.2% at price. This is slightly above the average 4.1% for muni CEFs.

But even if investors are chasing high absolute distributions, they should be aware that the fund's performance has been erratic. Though the fund's annualized total return to NAV is up 0.6% and 3.6% over one- and three-year periods, it lost 4.6% over the last five years. Comparatively, the Bank of America Merrill Lynch Municipal California Index gained 3.6%, 8.4%, and 4.7%, and leveraged California municipal CEF peers gained an average of 3.8%, 11.1%, and 3.4% over one-, three-, and five-year periods. Moreover, with a leverage-adjusted duration of 20.5, PCK has had volatile performance over this period. The fund's standard deviation of 13.2% and 13.9% over three- and five-year periods were much higher than the leveraged California municipal CEF averages of 7.4% and 8.5%.

Nuveen California Tax Free Income NXC
California investors might want to consider this fund as an alternative. Though NXC has a much lower distribution rate at NAV of 4.8%, its wide discount of 8.1% (compared to its three-year average of 5.7%) boosts this to 5.2%. The fund achieves this rate without using any leverage, so its core distribution rate at price is higher than PCK's. NXC's portfolio even has a higher average-weighted credit quality of BBB, compared with PCK's BBB- (Morningstar weights low-rated bonds more heavily when computing this metric).

Performance has also been notably smoother and higher than PCK, with one-, three-, and five-year annualized total returns to NAV at 5.3%, 8.2%, and 4.3%, and standard deviations over three- and five-year periods of 3.4% and 4.0%. NXC also charges less: its fiscal 2010 expense ratio of 0.38% is much lower than the muni CEF average of 1.10%, while PCK charged 1.34% the same year.

Steven Pikelny is a closed-end fund analyst at Morningstar.
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