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Is There Trouble Ahead for Muni Funds?

If investors don't watch out, their fund might get hit by changes in the yield curve. 

Steven Pikelny, 04/20/2012

With short-term interest rates hovering near zero for more than three years, leveraged municipal closed-end funds, or CEFs, have been a popular source of income for yield-starved investors. In 2011, most muni CEFs paid distributions in excess of 6% of net asset value. Equally impressive, these funds experienced significant capital appreciation: The average fund in the muni category grew nearly 10%, while the S&P 500 remained unchanged, and the price of gold increased 13%. In all, these funds had average total returns (including distributions) of 18% in 2011. Who would have thought that boring old muni funds could beat gold as the eurozone crisis raged?

It appears that the group is on track to log similar performance in 2012. From a NAV standpoint, the group has returned an average 5.9% for the year to date. But before betting the house on a muni fund, investors should note that it is unlikely for this stellar performance to continue. The ability to provide high distributions and capital appreciation simultaneously over the past year can largely be attributed to favorable changes in interest rates and the shape of the yield curve. Although these factors may be difficult to predict, investors should be aware of how they can potentially impact the future of these funds.

What Drove Performance in 2011?
After the financial crisis of 2008, the Federal Reserve lowered interest rates to unprecedented levels. Because long-term interest rates remained relatively high, the policy created one of the steepest yield curves of the past 20 years. Leveraged municipal CEFs were able to take advantage of this because their cost of leverage is typically tied to short-term interest rates and they tend to invest at the long end of the curve. This allowed the funds to effectively capture the difference between the two ends of the yield curve, borrowing money at low short-term rates and reinvesting at higher longer-term rates. The yield curve remained incredibly steep through most of 2011, allowing funds to continue reaping the benefits of this profitable income-producing strategy.

Meanwhile, a variety of factors relating specifically to the municipal market led to rapid capital appreciation. Increased confidence over municipal credit quality, changes in investor risk sentiment around the eurozone crisis, and limited issuance of new municipal debt are some of the reasons. Despite the inverse relationship between bond prices and interest rates, these funds were able to maintain the absolute level of their distributions because coupon payments from underlying holdings stayed level.

Short-Term and Long-Term Risks
Recently, the yield curve has flattened, and yields across all maturities are now lower. One obvious conclusion is that there is simply less low-hanging fruit for municipal funds to pick. But a less-optimistic viewpoint is that the future of the yield curve could easily spell trouble for municipal funds.

In a low interest-rate environment, one risk that presents itself is reinvestment risk. As short-term bonds mature, managers are forced to look for other options yielding similar levels of income. This is also a problem for portfolios with longer maturities, as many bonds with maturities longer than nine years have call options. This gives municipalities the option to replace higher-yielding debt with new, lower-yielding debt. Portfolio managers will have to reinvest the called bonds' principal at rates much lower rates than those of the called bond. Although many funds actively manage their call risk by turning over bonds before the option takes effect, managers still have to find alternative bonds when selling before call options kick in. Any way you slice it, reinvestment rate risk is a problem.

With lower income-generation potential, many funds will either be forced to cut distributions, deplete their reserves of undistributed net investment income, or return capital to shareholders. Alternatively, funds can supplement income by investing in lower-quality bonds (which typically pay higher rates) or moving further out on the yield curve (longer-dated bonds tend to pay higher rates as well). Both of these options can be risky, however, because the prices of these bonds are typically more sensitive to changes in interest rates.

The Fed has pledged to keep short-term interest rates near zero through 2014 and has implemented a maturity extension program (better known as "Operation Twist") to lower long-term rates. Taking this into consideration, investors should expect reinvestment risk to remain present into the near future. Looking farther ahead, the global economy might improve, investor sentiment might shift to riskier assets, and the Fed might raise interest rates. This would ultimately help these funds in terms of reinvesting assets but would lead to capital depreciation (this is because of the inverse relationship between bond prices and interest rates).‚Äč

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