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By Jason Stipp | 02-14-2012 10:00 AM

Three Closed-End Funds for Muni Fans

Because of their distinctive structure, closed-end funds could offer investors a leg up in the muni market, but be sure to get comfortable with the quirks of CEFs before investing.

Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax-Wise Investing Week on, and today, we're talking about municipal-bond investing and why investors should consider a quirky investment type--the closed-end fund--as a possible candidate to get their muni exposure.

I'm here today with closed-end fund analyst Steven Pikelny, and he's going to offer us some insights into that.

Thanks for joining me, Steven.

Steven Pikelny: Thanks for having me.

Stipp: So, before we talk about closed-end funds specifically, there are a lot of reasons why investors may want to look to a managed product, such as a fund, open-end or closed-end, for their muni exposure. What are some of those reasons?

Pikelny: I think that municipal bonds are good because, first of all, they are tax-exempt, which a lot of people find very attractive, and second of all, outside of the Great Depression, they have traditionally been a very safe asset class. Their default rate is a lot lower, their recovery rate when they do default is a lot higher. So, for investors that tend to be risk-averse and income oriented, I think that they are very attractive.

Stipp: So, investors could go out and buy individual municipal bonds on their own or they could use something like a mutual fund or a closed-end fund, and you say that there are some advantages to actually using a managed product over buying those individual bonds yourself. Why would you want to think about a mutual fund in this case, or a closed-end fund?

Pikelny: I think one of the biggest difficulties for an individual investor in trying to break into the municipal market is the fact that muni bonds are pretty illiquid. You have to go through a broker-dealer if you want to buy them; they don't just trade on an exchange like a stock does. There are tens of thousands of municipal issuers out there. So, it can be difficult to do research. And even from a more practical perspective, municipal bonds can be very expensive in absolute terms. So, that can make it difficult to create a diversified portfolio.

Stipp: So you recently did a study, and you looked at how people were investing in municipal bonds, the number of people that were investing through open-end funds and also through closed-end funds. You found that most of the assets that are going through funds are using mutual funds, but ... actually a big proportion of closed-end funds invest in municipals, even though closed-end funds, as a total, are only about 3% of the investments in municipal bonds.

You say there are some good reasons that investors should consider closed-end funds for this exposure. What are some of the main ones?

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