Discounts Increasing on Muni Bond Funds
Thursday, June 13, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 33.0%, up 3.5 points
  Neutral: 32.4%, up 0.9 points
  Bearish: 34.6%, down 4.4 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

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Whenever turbulence occurs in the financial markets, opportunities can be created in closed-end funds. This is happening currently with municipal bond closed-end funds. The recent rise in interest rates has several such funds trading at discounts not seen in at least two years, when fears about credit quality dragged down municipal bond prices.

The discounts are the difference in the funds’ share prices and the value of their underlying assets, or net asset value (NAV). For those of you unfamiliar with closed-end funds, these are funds that trade with a fixed number of shares. Mutual funds, conversely, are open-ended funds because the number of shares outstanding varies depending on deposits into (inflows) and withdrawals from (outflows) the fund. Since there is always a finite number of shares outstanding, the market value of a closed-end fund can, and often does, vary from its NAV. (Some closed-end funds can sell more shares to the public, but such secondary offerings are infrequent.)

The variance in a fund’s price can allow an investor to buy a dollar’s worth of investment for less than a dollar. If shares of a closed-end fund are trading at a 9% discount, you can acquire $1 of assets for $0.91. The upside of this is that you can then potentially profit from both the capital appreciation of the underlying assets and any increase in the fund’s price back toward its net asset value. This double potential for reward is why even index fund advocate Burton Malkiel thinks actively managed closed-end funds can make good investments if bought at a big enough discount.

Even when a closed-end fund is trading at a discount, gains are not guaranteed, however. Some funds routinely trade at discounts, so you have to look at the historical data. The Closed-End Fund Association’s website (www.cefa.com) shows a fund’s premium and discount range for the past 10 years. I always look at this when evaluating a fund to ensure the current discount is attractive relative to a fund’s history.

There are other factors that should be considered as well. Closed-end funds are actively managed funds, so management tenure, performance and expense ratios should all be considered. The type of assets invested in should also be looked at. Some closed-end funds use leverage and/or have high turnover. In other words, as is the case with any investment, know what you are getting into before placing the trade.

With municipal bond closed-end funds, the discounts are starting to get attractive on some funds. Many of these funds also have yields above 5%. Accompanying these yields is a widespread use of leverage, which magnifies any loss resulting from a further rise in interest rates, however. (The use of leverage will add a boost to performance if interest rates pull back from current levels.) The use of leverage is important to consider because the current discounts to NAV may not be big enough to offset potential capital losses if interest rates do continue to rise.

Still, for risk-tolerant investors, it may be worth the effort to take a closer look at the municipal bond closed-end funds. Here is a brief listing of funds with expense ratios no more than 1.5% that are trading at bigger discounts to their NAV than they historically have. (Note: I have not looked at these closely, so read the prospectuses carefully.)

Closed-End Fund Ticker Discount
Putnam Municipal Opportunities Trust PMO 11.16%
Western Asset Municipal High Income Fund  MHF 10.82%
MFS Investment Grade Municipal Trust  CXH 10.70%
Invesco Quality Municipal Income Trust IQI 10.55%
BlackRock MuniAssets Fund MUA 10.11%
Source: CEFA, data as of 6/12/13



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The Week Ahead

We will get our first glance at second-quarter earnings, as the early reporters announce their results next week. Among the eight S&P 500 members on the calendar are Adobe Systems (ADBE) on Tuesday, FedEx (FDX) on Wednesday, Oracle (ORCL) on Thursday and Darden Restaurants (DRI) on Friday.

Federal Reserve Chairman Ben Bernanke will hold his quarterly press conference on Wednesday at 2:30 p.m. ET. The statement from the two-day Federal Open Market Committee and members’ forecasts will be released a half hour prior. Elsewhere on the economic calendar, the June National Association of Home Builders housing index and the June Empire State manufacturing survey will be the week’s first economic reports, published on Monday. Tuesday will feature the May Consumer Price Index (CPI) and May housing starts and building permits. May existing home sales and the June Philadelphia Federal Reserve Survey will be published on Thursday.

Friday is a quadruple witching day, meaning both options and futures contract expire.

AAII Sentiment Survey

Pessimism declined this week, though the rebound in optimism was not enough to push it back above its historical average in the latest AAII Sentiment Survey. Bullish sentiment, expectations that stock prices will rise over the next six months, rose 3.5 percentage points to 33.0%. This is the third consecutive week and the 13th out of the last 16 weeks that optimism has been below its historical average of 39.0%. Neutral sentiment, expectations that stock prices will stay essentially unchanged, edged up 0.9 percentage points to 32.4%. This is the third consecutive week and the ninth in the past 12 weeks that neutral sentiment is above its historical average of 30.5%. Bearish sentiment, expectations that stock prices will fall over the next six months, fell 4.4 percentage points to 34.6%. This is the second consecutive week that pessimism is above its historical average of 30.5%. We are continuing to see volatility in sentiment, a sign of the ongoing uncertainty about market direction. As I noted last week, bullish sentiment has fluctuated within a 26.1-point range and bearish sentiment has fluctuated within a 32.9-point range since the start of March. This week’s readings for bullish, neutral and bearish sentiment are all within their typical historical ranges. Worries about the effect of a change in Federal Reserve policy lessened this week. Prevailing valuations, the slow pace of economic growth and a lack of progress on key issues by the White House and Congress continue to concern many AAII members. Others, however, are encouraged by the length of the current rally and signs of continued economic growth. This week's special question asked AAII members what economic trends they are currently watching. The state of the labor market was the most popular trend, named by 36% of respondents. Interest rates and the bond market was a close second, listed by 32% of respondents. Federal policy ranked third, cited by 17% of respondents. Notably, Japan is being monitored as closely as China is, with 7% of respondents saying they were following events in one or both countries. (Many AAII members listed more than one economic indicator in response to the special question.)

» Take the sentiment survey