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  1. Munis Still Worth a Look

    With a tilt toward longer durations, worries over Puerto Rico, and large outflows, muni funds struggled in 2013, but they have something to offer investors, says Morningstar's Eric Jacobson.

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Year in Review: Municipal CEFs

2013 was not a pretty year for investors in municipal closed-end funds.

Steven Pikelny, 01/03/2014

Normally regarded as a sleepy--and "safe"--asset class, municipal bonds were hammered in 2013. In fact, munis were hit twofold: first by rising interest rates, and then by credit concerns. After a spectacular run in 2012, many muni investors were likely disappointed. For example, the largest muni exchange-traded fund, iShares National AMT-Free Municipal Bond MUB, which tracks the S&P National AMT-Free Municipal Bond Index, lost 3.0% for the year after returning 5.2% in 2012 and 13.0% in 2011. But this was still relatively tame compared with the carnage among muni closed-end funds. These CEFs typically use leverage, focus on the longer end of the yield curve, and go after securities with greater credit risk--all of which amplified the volatile movements in the broad muni market. To make matters worse, discounts rapidly widened throughout the sector as investors pulled out of their muni positions. By year-end, the average muni CEF had lost 6.8% on a net asset value basis and 13.0% on a share price basis. Let's take a closer look at what happened over the course of the year.

The Muni Market
Going into 2013, U.S. Treasury rates were at historic lows--in early January, the 10-year rate hovered around 1.9%, while the Bank of America Merrill Lynch 7-12 Year Municipal Index yielded close to 1.7%. By early May, the 10-year Treasury rate dropped to 1.7%, but the Federal Reserve's mere mention of tapering the bond-buying program jostled the market, sending long-term rates to 2.7% by July. Over the same time frame, the yield on the 7-12 year municipal index shot up to about 2.5% in mid-July from 1.6% in early May. Even worse, the yield on the 12-22 year muni index rose about 140 basis points over the period, to 3.7% from 2.3%. Considering that the prices of longer-maturity bonds are particularly sensitive to changes in rates, this subset of the muni market performed particularly poorly (for example, the 12-22 year index fell 7.0% over this period).

While credit concerns were not the main driver of muni returns, they were not entirely absent either. Detroit's high-profile default may have unnerved some investors and indirectly led to collateral damage among other low-quality muni bonds. The direct effects of the default were minimal, however. Detroit's bankruptcy was not a surprise for most muni-fund managers, and the city's uninsured general-obligation debt was largely omitted from muni portfolios. Puerto Rico, however, was a slightly different story. With $70 billion of outstanding debt issued by the island, these bonds were more present among fund portfolios (ETFs, CEFs, and open-end funds alike). Because the income from these bonds is typically exempt from state taxes, Puerto Rico was a surprisingly common holding in state-focused funds. In all, the S&P Municipal Bond Puerto Rico Index fell more than 20% in 2013.

Municipal Closed-End Fund Performance
In all, municipal CEF performance in 2013 left a lot to be desired. Below are the 10 best and worst performers for national and state muni CEFs.

Only three municipal CEFs logged positive NAV returns for 2013, and each was a term trust set to wind up in the next seven years. This means that they held shorter-maturity bonds, which are less sensitive to changes in interest rates. The remainder of the top performers were either focused on intermediate-duration municipal bonds by mandate or achieved shorter-than-average durations by eschewing leverage. The exception here was Nuveen Municipal High Income Opportunity NMZ. Even though Nuveen reports the leverage-adjusted duration of this high-yield muni fund to be longer than 14 years, its managers skillfully avoided the worst of the muni-market fallout but still picked up the higher coupons from riskier securities.

It's worth noting that even some of the best performers on a NAV basis were hit hard by widening discounts. While  Nuveen Select Tax-Free Income NXP and Federated Premier Intermediate Municipal FPT each limited portfolio losses to 4.2%, for example, investors saw share prices fall 10.5% and 11.4%, respectively.

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

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