We have received a flood of phone calls and emails from investors concerned about the performance of their closed-end municipal bond funds. These fund prices have not only declined substantially in recent months, but have in some cases actually stopped paying dividends – the very reason for which they were purchased.
“Was I wrong?” asked one investor. “I thought getting a higher yield through the fund was a good idea. Should I now switch to individual bonds?”
We understand his disappointment. Investors who have followed our Bond Forum responses over the years know that we are not enamored of bond funds in general or closed-end funds in particular. We are always leery of any mutual fund that generates a higher yield than the securities it holds.
We knew that the only way this could be accomplished was by a fund manager utilizing what has, since the start of the Wall Street financial crisis, become a dirty word: “Leverage.”
These funds are suffering from the same practices that have imperiled once- powerful Wall Street institutions: Using borrowed money to enhance their return on capital.
On a number of previous occasions, we suggested in our Bond Forum that these funds were not likely to perform well in a market environment characterized by rising yields and declining prices. Turns out, we were right.
How it worked
The typical closed-end fund issued a fixed number of common shares and was listed on a stock exchange. The leveraging, or borrowing, to boost returns was accomplished through the sale of auction-rate preferred shares (ARPS). The fund paid a lower interest rate on these preferred shares, which reset at auction every seven days (sound familiar?).
The money borrowed through these ARPS enabled the fund to increase its holdings of municipal bonds and thus enhanced the fund’s yield.
It is not difficult to understand why this promise of higher tax-free yields was attractive to investors.
Here’s the rub
The Investment Company Act of 1940 stipulates that for the funds to declare dividends, their total assets (NAV) must be at least twice the sum borrowed from the issuance of preferred shares.
Today, the illiquidity in the municipal bond market, which we have discussed in recent commentaries, has caused the asset value of the funds to approach or drop below this critical threshold. (See particularly “A Tale of Two Investors” and “What Mark to Market Means to You”)
This has resulted in a number of these funds postponing their dividends. Ironically this is a case of an investment purchased for its higher yield, which by not paying a dividend, provides no yield at all.
Unfortunately, even the funds which have not postponed dividends are being sold by investors hoping to avoid a similar fate, which results in these prices declining as well.
Be your own money manager
We invariably recommend taking responsibility for your own investments. Our firm does not accept discretionary accounts because we have long held the belief that municipal bonds should be bought and held for income rather than capital gains.
Selecting your own tax-free bonds with some assistance from a municipal bond specialist can provide you with a steady stream of call-protected, well diversified tax-free income. Unlike bond funds, individual bonds have a stated maturity date, which is of paramount importance.
As we always point out, your bonds will sometimes be worth more than you paid for them, and sometimes less, but there is always the promise of the return of principal at maturity.
We hope that individual investors, who have witnessed recent Wall Street scandals and financial institutions mismanaging their own funds, will be encouraged to take more responsibility for their own investments and be less confident in “professional money managers.”
