Three Closed-End Funds for Muni Fans

Pikelny: I think that because municipal bonds are so illiquid, the closed-end fund's capital structure is very conducive to that. Like the name says, a closed-end fund is closed. They have an initial IPO and the manager is working with a set amount of capital for the rest of the fund's life. And investing in an illiquid market, this can be pretty advantageous because the manager doesn't have to worry about investors pulling their money out or more investors putting money back into the fund.

So, if ... the manager sees a very attractive bond, for example, and they are worried that it might be too illiquid to get rid of quickly, then a closed-end fund manager can just as easily buy that, whereas an open-end fund manager has to consider the consequences of liquidating it, if they have to.

Stipp: So, we know that municipal bonds are very popular among individual investors, no matter ... what vehicle they are using. We also know individual investors can get spooked by the market or they can get overly exuberant in up markets, and so this hot money that flows in and out of municipal open-end funds can be difficult for those managers to invest or to get rid of their inventory if they need to meet redemptions. But a closed-end fund, you say, doesn’t have to worry about that, so, maybe they can be a little bit more nimble in what they invest in.

But I want to turn the conversation and talk a little bit about recent market activity. So, we have seen over the past couple of years with municipals, there have been worries about defaults, there have been prognostications of just disaster in the municipal market that actually haven’t come to pass. But there has been volatility. So, when you look at closed-end funds versus open-end funds, what are you seeing as far as how those funds have reacted to all of the market turmoil we've seen?

Pikelny: Well closed-end funds are interesting because while they don't have to deal with inflows and outflows of capital, they do trade at premiums and discounts, meaning the share prices are determined by supply and demand. So, they don't always necessarily correspond to the underlying net asset value of the fund.

So, when investor preference is high, for example, a lot of funds start trading at a premium, and that's really what we've seen in the last six months, which has been really interesting, because we've pretty much been in a very risk-off environment, with a lot of the stuff happening in Europe and a lot of fear over the United States government defaulting. So, a lot of investors have kind of turned to municipal bonds and municipal bond closed-end funds as a safe asset class.

So, while usually they trade at a discount, in the last six months or so, the discounts have narrowed. A lot of discounts have turned to premiums, and a lot of premiums have widened, which is pretty unusual for closed-end funds.

Stipp: Would you say that because we're starting to see very narrow discounts, or even some premiums, that now might not be necessarily the best time for investors to be looking into the municipal bonds through closed-end funds?

Pikelny: Well it's not the best time ever, but I still think that a lot of these funds are far from being wildly overvalued. I still think that they are in a good place and there is still some good value there.

Stipp: You mentioned the premium and discount, which is a phenomenon that happens with closed-end funds. If I was going to consider a closed-end fund and maybe I have been accustomed to using open-end funds for munis, what else do I need to know? What are some of the other attributes of closed-end funds that I should have on my radar?

Pikelny: Well, one is the discount, obviously, because it could make for a good deal because a lot of people trade closed-end funds in the short term, but still at the same time I think that closed-end funds are a good vehicle for a long-term investment, because if you're willing to hold on for the ride, then everything usually works out. Like in 2008, for example, when investors were completely freaking out, and the discounts in a lot of these funds blew out, but since the prices are determined by supply and demand, a lot of investors realized that there wasn’t really that much to worry about, and the discounts closed pretty soon afterwards. So, if you're buying a closed-end fund, you have to be aware of that risk and realize that it's not as bad as it seems.

Stipp: You were mentioning before that sometimes these discounts can persist for quite a while. So, even if you buy at a discount, it doesn't necessarily mean that the discount will close; you just be aware of what's the normal discount for this kind of fund.

Pikelny: A lot of people see a fund trading at maybe a 10% discount, and they think, "Oh, I'm getting these assets for 90 cents on the dollar," and that might not necessarily be true, because a lot of funds are always trading at a 10% discount. So, it's important to keep the historical perspective in mind.

Stipp: What about leverage? Because of the structure of the closed-end fund, they can take on leverage, which is not something you typically see in the open-end fund universe. What should I keep in mind about leverage, and specifically, do a lot of municipal-bond closed-end funds use leverage?

Pikelny: Well, because municipal bonds are considered to be fairly safe, leverage is a very popular strategy in the muni closed-end fund universe. It's something that you have to watch out for, but I think at the end of the day, if used properly, then leverage can be a useful tool.

For example, PCK, which is a PIMCO fund, is currently paying a 7.4% distribution rate, which is high, and especially when you consider the fact that it's tax-exempt, you don't have to pay federal or California state taxes on it (because it's a California fund), but then once you consider the fact that half of that is coming from leverage, it becomes a little bit less attractive.

But a lot of funds, maybe about a third of their income comes from leverage, and they're paying closer to a 6% distribution rate, and that still might be a little riskier than a lot of investors are willing to consider, but it's still pretty attractive.

Stipp: So, the leverage, we know, can cut both ways. What should you keep in mind if you do take on a lot of leverage, and we hit a rough spot for the muni market? That would amplify on the downside as well, right?

Pikelny: It would amplify on the downside as well, but then you have to also take into consideration that it will amplify on the upside. When the market recovers, then you'll get that extra boost.

But even if you don't like the leverage, there are still plenty of closed-end funds that don't use any leverage and ... at least anecdotally, they have the advantage of investing in more illiquid assets, and the manager has that extra benefit there. They still have pretty good performance.

Stipp: Let's talk about some of the funds that you like in this space, what some of your favorites are. You mentioned a couple in there, and also some of the things that investors should look out for.

Do you have a short list of funds that you might recommend investors take a look at first?

Pikelny: First is one fund that is unleveraged, MTT, which is a Western Asset fund. They don't use leverage, and their portfolio quality is relatively high, and they're currently paying around a 4.4% distribution rate. Like I said, they're not leveraged, so ... their distribution rate is lower than the average for municipal closed-end funds, but it's still pretty attractive in the general scheme of things.

One is MHI, if your risk tolerance is a little higher. This is a Pioneer fund. It's also paying a 7.4% distribution rate, like the PIMCO fund, but its ... leverage ratio is a lot lower, and its portfolio quality is generally a little bit higher.

Then finally, there is BLE, BlackRock Municipal Income, which is right in the middle. They're paying a 6.4% distribution rate, and that's around the average. ... That distribution rate is a little higher than average for a lot of municipal closed-end funds, but in terms of its leverage and its credit quality, it's pretty much right in the middle.

Stipp: Well, it sounds like closed-end funds are certainly an interesting option for investors to take a look at to get exposure to municipal bonds. Thanks for joining me today and for your investment ideas.

Pikelny: My pleasure.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.