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By Jeremy Glaser and Steven Pikelny | 09-19-2012 01:00 PM

Keep an Eye on Muni Calls

As the Fed intends to keep interest rates low for the next few years, muni-CEF investors should maintain a close watch on their funds' call exposure.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. With the Federal Reserve committing to another round of bond buying and also to keeping rates very low until at least the middle of 2015, many municipal-bond investors wonder what that could mean for their portfolios. I'm here today with closed-end fund analyst, Steve Pikelny. We're going to look at how it could affect these funds.

Steve, thanks for joining me today.

Steve Pikelny: Thanks for having me.

Glaser: Let's talk a little bit about what the Fed announced, so-called QE3. Can you walk us through what impact that could have on municipal bonds, generally?

Pikelny: Sure. Well, the Federal Reserve announced that they're going to try and continue to keep the yield curve relatively flat and have yields across the yield curve at pretty low rates. Municipal bonds are traditionally pretty highly correlated with Treasuries because a lot of these bonds are seen as being very safe from a credit-quality standpoint. So, this means that municipal bonds will also likely see very low rates for the near future.

One thing you have to worry about with this is reinvestment risk because many municipal bonds around the eight-year mark or so have a call option. So, for many municipalities seeing this very low-interest-rate environment, if they have the option, they're probably going to want to call their bonds, so they could refinance at low rates than what they have now.

Glaser: How about closed-end funds in this environment? Is that reinvestment risk a big threat to closed-end fund investors?

Pikelny: It's a threat for some of the closed-end funds. The thing you have to keep in mind with a lot of these closed-end funds is that since they have a closed capital structure, they don't have to go out and reinvest any money they receive from inflows. So, they're sitting on a portfolio and they might trade some of the portfolio, but for the most part it's kind of just sitting there.

They have this portfolio, and the portfolio receives coupon payments. And depending on how prices move, the yield might fluctuate, but the fund is actually sitting on the same amount of investment income. So, for funds that have high call exposure, they might have to cut their distributions if they're receiving less income from when some of these bonds are called.

Glaser: What are some of those funds that have that higher call exposure?

Pikelny: Well, a lot of Nuveen funds actually have pretty high call exposure. I think two of the highest are NPF and NPI, which each have upward of 60% of their portfolios exposed to callable bonds within the next four years or so. Alternatively, there are a number of funds that have less than 10% of their portfolio callable in that time frame.

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