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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.

Minnesota Municipal Income II MXN
This Minnesota municipal fund is like William H Macy's character in the movie Fargo: You may own it for years and think you know it intimately. But while it appears honest and highly dependable on the outside, it might not be as stable as you think. One of three Minnesota CEFs, MXN boasts annualized NAV total returns of 4.4%, 14.7%, and 5.2% over one-, three-, and five-year periods, which are higher than the entire muni CEF category averages of 3.5%, 11.9%, and 4.3%. What's more, managers Douglas J. White and Christopher L. Drahn are both asset-manager veterans, with 23 years and 17 years of experience, respectively. On first glance, this small fund, with $34.7 million in total assets, appears to be a savior for Minnesota investors looking for tax-free income and a gem for those living out-of-state.

Unfortunately, this fund does not have much else going for it outside of its past performance and manager experience. The fund is currently trading at a 5.4% premium, which knocks down its distribution rate to 5.2% at price from 5.5% at NAV. After accounting for the fund's slightly higher than average leverage ratio at 1.61 (the muni CEF average is 1.55), the fund's core distribution rate is one of the lowest of any muni CEF at 3.2%.

Though the fund's standard deviations over three- and five-year periods were only 6.8% and 7.6%, its future might not be as rosy. The fund has a large exposure to unrated muni bonds (which have historically had much higher credit risk than rated bonds), giving it an average-weighted credit rating of BBB-. This, along with its leverage, gives the fund a very high effective duration (a measure of interest-rate sensitivity) of 25.6, indicating that its portfolio is very sensitive to changes in interest rates.

Delaware Investments Minnesota Municipal Income II VMM
Investors looking for exposure to the Minnesota muni market, be it for portfolio diversification or extra tax-exemption, might want to consider this fund instead. Though the fund has had mediocre absolute performance (with annualized total return to NAV of 3.7%, 8.3%, and 3.7% over one-, three-, and five-year periods), it has been incredibly stable, with very low standard deviations of 3.0% and 4.7% over three- and five-year periods.

One of this fund's main lures is its high discount of 8.5%. Though it has traded at a similar discount over the past five years, this boosts the fund's distribution of 4.0% at NAV to 4.4% at price. Considering that the fund uses no leverage and has a higher average-weighted credit quality than MXN of BBB, its core distribution is about one third higher than MXN's. This fund also had much lower fees, an expense ratio of 0.56% in fiscal 2010, compared with MXN's 1.87%.

Eaton Vance New York Municipal Bond II NYH
This fund is similar to Mia Farrow's neighbors in the New York horror classic Rosemary's Baby. It might seem endearing at first, with its higher than average-weighted credit rating of BBB+ and distribution rate of 6.66% at NAV; but it ultimately has to resort to using some dark magic to get these returns. Like many of the funds on this list, a single glance at its distribution rate could be deceiving without checking its leverage. Once one adjusts for the fund's 1.78 leverage ratio and 2.1% premium, he or she is left with a core distribution rate of 3.6% at price.

The fund's high leverage has led to mixed returns and higher volatility. The fund outperformed its peers and benchmark over the last three annualized years with a total return to NAV of 12.0%, compared with the average leveraged New York municipal CEF's 11.1% and the Bank of America Merrill Lynch New York Municipal Index's 8.2%. Over one- and five- year periods, the fund's annualized total returns of 2.1% and 2.4% underperformed the benchmark's 3.3% and 4.9% and the peer average of 3.7% and 3.9%. Despite this performance, the fund had high NAV standard deviations of 10.6% and 12.2% over three- and five-year periods, compared with the peer averages of 6.5% and 7.6%, respectively.

Nuveen New York Select Tax Free Income NYH
This fund might look bland at first sight with a 4.7% distribution rate at price, and 4.7%, 7.9%, and 4.6% annualized total returns to NAV over one-, three-, and five-year periods. But New Yorkers might want to consider NXN as a lower-risk alternative to NYH, as it employs no leverage and has been less volatile: The fund has had low standard deviations of 3.0% and 3.8% over three- and five-year periods. What's more, the fund had the lowest expense ratio in fiscal 2010 of all New York muni CEFs at 0.41%, compared with the peer-group average of 1.14%. While NYH's expense ratio of 1.41% was not quite as high a price as selling your unborn son to the devil, it was still quite pricey.

These funds are not necessarily good or bad, but each has a risk-return trade-off that might not be self-evident at first glance. Some funds offering high-distribution rates on the outside are actually highly leveraged with low-quality portfolios. Other funds offering seemingly humdrum distribution rates are safer and offer investors a better chance of raking in the investment "candy" for years to come. When evaluating any CEF, it's important to look past the superficial appearances (touted brand names, high distribution rates, and so on) and to examine what lies underneath. Doing so will set you up for a munificent Thanksgiving.

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