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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

In the meantime, long-term rates can still fall, despite the current historically low levels. This would give a boost to the market prices of longer maturity bonds but would make reinvesting in high-yielding bonds even more difficult. (Short-term rates cannot fall simply because, at essentially zero, there is no room for them to fall). Nevertheless, extreme economic calamity could increase the value of muni funds' portfolios, despite low interest rates. Such an environment could also rekindle fears of municipal credit risk, potentially offsetting some of the gains.

To be clear, these problems affect muni funds of all types: open-end, closed-end, leveraged, and nonleveraged. However, leveraged funds face an added risk in the flattening of the yield curve (that is, short-term rates rising, long-term rates falling, or a combination of the two). This would increase the cost of using leverage and ultimately decrease its profitability. CEF investors also have to worry about changes in funds' respective discount or premium. A distribution cut, for example, could hit investors twice: in terms of lower income and in terms of share price depreciation. Similarly, depreciation of underlying assets could lead to a widening discount.

Picking the Right Funds
Picking a muni fund in the current interest-rate environment can be difficult because the same qualities that protect against the risk of a distribution cut in the short term can exacerbate the risk of capital depreciation in the long term, and vice versa. To protect against the former, investors should primarily look for funds with lower exposure to bonds callable within the next five years and higher exposure to long maturities. This lessens the risk of having to reinvest funds in the near future. CEFs have an intrinsic advantage over open-end funds and exchange-traded funds in this arena because they are not subject to inflows and are therefore not forced to reinvest inflows. Another attractive quality is a high UNII balance. This would provide a fund with a reserve to draw on if investment income decreases.

Two funds that satisfy these criteria are BlackRock MuniYield Investment Quality MFT and DWS Municipal Income KTF. Less than 9% of MFT's portfolio is either callable or has a maturity date before 2017, so reinvestment risk is not a pressing problem. Moreover, the fund has a UNII reserve of $0.2519 per share, enough to cover about 3.5 months of its current distribution. Similarly, about 13% of KTF's portfolio is callable within the next five years, and the fund has a UNII reserve of $0.4097 per share (equal to about six months of its current distribution). Both funds are currently earning enough income to cover their distributions without dipping into their respective UNIIs. MFT and KTF pay distribution rates of 5.9% and 6.1% at share price, respectively.

Both of these funds have built up their UNII reserves by using leverage and continue to do so. MFT has a leverage ratio (total assets/net assets) of 1.64, while KTF has a leverage ratio of 1.65. (The average municipal CEF has a leverage ratio of about 1.50). If bond prices begin to fall, leverage will amplify the resulting capital depreciation. Investors worried about this may want to steer clear of highly leveraged funds, which include a large portion of municipal CEFs. Many of the CEFs that use small amounts of leverage also have high exposure to callable bonds in the next five years.

For investors who are willing to accept a lower distribution rate (4.4% at share price) and a lower UNII cushion, Western Asset Municipal Defined Opportunity MTT might be a suitable alternative. This fund does not use leverage, and only 7.3% of the portfolio is callable in the next five years.

Overall, investors should be aware that 2011 was not a representative sample of typical municipal CEF performance. When the factors that led to high distributions and capital appreciation reverse course, this should become even clearer. Nevertheless, investors should avoid making interest-rate bets because of the difficulty in predicting the future course of the yield curve; however, it is possible to gauge how a fund could react to different interest-rate scenarios, and investors should factor this into their research.

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