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Muni CEFs Still Safe Source of Income

Jeremy Glaser
Steven Pikelny

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Interest in municipal bonds remains sky-high as investors seek tax-free income. I'm here with Steve Pikelny, a closed-end fund analyst, to get an update on the sector. Steve, thanks for talking with me today.

Steven Pikelny: I'm glad to be here.

Glaser: Let’s start with just getting a quick update on muni market. How have those bonds been performing?

Pikelny: During the last year, muni bonds have rallied pretty heavily, mainly because a lot of investors were freaking out about everything going on in Europe. And because municipal bonds are traditionally seen as a low-risk asset class, as kind of the risk-off sentiment kind of took hold, they've seen a lot of price appreciation.

Glaser: Certainly, they historically have had that low-risk profile, but time and time again we hear these stories of municipal bankruptcies. We hear lots of concerns about this credit quality potentially not being so strong. How are those concerns being played out through the market, and are these well-founded?

Pikelny: Around the end of 2010 Meredith Whitney predicted that the muni market will just face an Armageddon of sorts in 2011. Even though that didn't necessarily pan out last year and her timing was obviously off, it doesn’t necessarily mean that the muni market is completely risk-free. A lot of states are facing pretty high Medicaid and pension obligations. You’ve seen a couple of high-profile defaults in the muni market, such as Stockton, Calif. These have been pretty rare for the most part, but they do happen.

Glaser: It sounds like some of these credit events are pretty isolated.

Pikelny: For the most part, they are isolated. Even if there is some increased credit risk in the muni market compared with other asset classes, such as corporate bonds, they are still relatively safe.

Glaser: What's the demand been like for closed-end funds that hold muni bonds?

Pikelny: Over the last year or so, it's been really interesting because a lot of these closed-end funds went from what they’ve historically traded at, at discounts, they've gone to premiums. And actually right now the average municipal closed-end fund is trading at a 2.5% premium.

Glaser: As you said before, income really is what people are trying to get out of these muni bonds. What do the distributions look like from this closed-end funds.

Pikelny: So far this year, a lot of muni closed-end funds have actually cut their distributions. The vast majority of them have kept the distributions, but I think more often than not we've seen that they've cut them as opposed to raising them. I think that it is driven by two main factors. One is the fact that a lot of funds are trying to consolidate the funds because you have lot of fund families that have 20 or so muni funds with the same strategy, and in order to do that they have to refinance some of their leverage. While they used to have preferred shares such as auction-rate preferreds, now they have to refinance into other preferred shares such as variable-rate-demand preferred shares, and these are typically little bit more expensive. So that's going to cut into the income that they could give out to distributions.

The second thing that has been going on is since we're in such a very low-interest-rate environment right now, a lot of munis that have call features on them are being called, and that presents some reinvestment risk for these funds.

Glaser: Let's look forward then. Do these muni funds really make sense as a way to get income, or are interest rates so low right now that investors should be looking elsewhere?

Pikelny: Ironically enough, the low interest rates are what's helping them right now because since short-term interest rates are so low, they could afford to essentially borrow at the near-zero short-term rate and then reinvest that on the longer end of the yield curve. So whenever they leverage up their assets, they are getting kind of the spread between that on their portfolio. As long as interest rates stay low, they are still going to be able to provide that increased income, and I think that when the Federal Reserve decides to raise interest rates finally, that might be a cause for concern for some of these funds.

Glaser: How about credit quality? So far, you mentioned that it seems like they are pretty isolated issues, but do you see that credit quality really deteriorating in the coming years?

Pikelny: Well, for the most part these funds have pretty diversified portfolios, so if one or two bonds default, it won’t be the end of the world for them. Even when they do default, usually municipal bonds have pretty a high recovery rate. So if you have a default then you might get 95% of your money back or 60% of your money back on the individual issue. So it might not necessarily be a huge deal.

Glaser: Steve, thanks for talking with me today.

Pikelny: Yes, thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.