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Closed-End Muni Fund
Old 07-21-2005, 04:31 PM   #1
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Closed-End Muni Fund

Hi Folks,
I have been doing some reallocation of my portfolio this year, trying to diversify what was a portfolio of about 80% domestic stock.
One thing I have been thinking about is picking up a closed-end bond fund selling at a bit of a discount. The one I am looking at happens to be a muni fund that is currently yielding 6.2%. I figure this is 8.2% effective taxable return for my tax bracket.
The average duration on this fund is 8 years with an "effective duration of 6.5 years. (To be honest, I'm not really sure I understand how they lower the duration, but I think it has to do with selling options on the bonds.)

So I figure my interest rate risk here is acceptable, in that a rate hike of 1% would eat about 1 years worth of returns.

Since this is a "high-yield" muni-bond fund, there is some default risk, but only 50% of the bonds in the fund are below inv. grade, and from what I have read on the net, it is fairly rare for a muni to default (usually only happens if they are municipal projects backed by failing corporations.)

Do you folks have some opinions on this? Is the 6.2 yield maintainable? If so, that is very acceptable to me.
Theoretically, I know I can earn more in equities over the next 20 years, but a chance to earn 8%+ reliably is hard to pass up.

My current goal is to retire in 15-20 years.
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Re: Closed-End Muni Fund
Old 07-21-2005, 04:35 PM   #2
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Re: Closed-End Muni Fund

Which fund? High-yield muni funds generally get their high-yield through leverage. Leverage, of course, works both ways. It increases your returns during good times, and increases your losses during bad times.
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Re: Closed-End Muni Fund
Old 07-21-2005, 04:38 PM   #3
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Re: Closed-End Muni Fund

What's the symbol?

Here are a few explanations & potential gotchas:

- Effective duration is lower than the actual bond duration because they are using derivatives to lower the effective duration. *The most common ways to do this are entering into a pay fixed, receive floating swap, or by selling long bond futures.

- Is this fund leveraged? *If so, they have effectively ramped up the credit risk in the portfolio.

- What is your tax status? *Most of those bonds probably aren't tax-free if you are subject to AMT.

- Low grade munis typically have far lower default rates than similarly-rated corporate bonds. *However, defaults still do occur. *You want to make sure that the manager has a good track record.

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Re: Closed-End Muni Fund
Old 07-21-2005, 04:48 PM   #4
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Re: Closed-End Muni Fund

Quote:
Originally Posted by brewer12345
What's the symbol?

Here are a few explanations & potential gotchas:

- Effective duration is lower than the actual bond duration because they are using derivatives to lower the effective duration. The most common ways to do this are entering into a pay fixed, receive floating swap, or by selling long bond futures.

- Is this fund leveraged? If so, they have effectively ramped up the credit risk in the portfolio.

- What is your tax status? Most of those bonds probably aren't tax-free if you are subject to AMT.

- Low grade munis typically have far lower default rates than similarly-rated corporate bonds. However, defaults still do occur. You want to make sure that the manager has a good track record.
I wasn't sure if it was against forum rules to post the actual stock/fund name. Two funds -- very similar, same company, both use leverage: MAV and MHI

I have never fallen under AMT subjection, and don't believe I will any time soon.

I haven't looked into the managers' track records. I'll see what I can find out. (Both of these funds are relatively new, so it may take some digging.)
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Re: Closed-End Muni Fund
Old 07-21-2005, 05:18 PM   #5
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Re: Closed-End Muni Fund

Hi Dan,
I'm still getting my hips wet with CEF Munis. I like them so much I use them in IRAs.
I stay away from leverage. Yield is lower around 5% range.
I use ETFConnect.com and Morningstar.com to evaluate CEF and ETF
ETFConnect (Mult-fund search tool) will indicate leverage, discount/Premium, grade, etc.

I'm partial lately to Nuveen for Muni - NUV etc.
I've also been in and out of BlackRock and Pimco for a broader range of CEF - not just muni.

My Muni CEFs have had a good run lately. 5-6% gain besides the monthly payout last 4 months.
I wouldn't be shocked if they go back to their 200 day moving average or lower sometime sooner or later - who knows in this world and market today. If so, your total retun will be 0 or less. So be careful out there.

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Re: Closed-End Muni Fund
Old 07-22-2005, 07:20 AM   #6
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Re: Closed-End Muni Fund

Both MAV and MHI have only been around for a year or two, with a 1.1% expense ratio. The ER isn't completely out of this world for a CEF, but it may explain some of the discount to NAV (~5%). You'd really want to do your due dilligence on the managers here before buying.

Personally, I am only interested n buying a VEF whe I can get it at a fat discount. For something like GIM with a long track record, no leverage and modest expenses, 5% is a solid discount. For something with leverage and bigger expenses, I'm not readdy to jump until I see a 10% discount to NAV.
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Re: Closed-End Muni Fund
Old 07-22-2005, 10:06 AM   #7
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Re: Closed-End Muni Fund

"The average duration on this fund is 8 years with an "effective duration of 6.5 years."

The effective duration factors in the puttable and callable features (options) on the bonds.

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Re: Closed-End Muni Fund
Old 07-28-2005, 12:59 PM   #8
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Re: Closed-End Muni Fund

I still haven't made a move on this, but I've started looking for funds with shorter durations. (I've also decided against Munis and decided to go with corporates held in a non-taxable account.)
I've found a couple (for example the Eaton Vance Limited Duration) which have durations ~2 years, but the even with a nice 8% dividend, the market return on these funds for the last few years has stunk (1.5%).

Is there a measurement for bonds (like sharpe ratio or beta in the stock world) that measures the volitility of the market price of bonds?
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Re: Closed-End Muni Fund
Old 07-28-2005, 01:15 PM   #9
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Re: Closed-End Muni Fund

I suppose you could use boring old volatility and correlation with the S&P 500.

Duration is typically used to indicate interest rate sensitivity. The other major risk in fixed income is credit risk. An admittedly crude way to measure this is the spread over treasuries or LIBOR. If the Eaton Vance fund has a yield of 8% and a duration of about 2, you are talking about 500BP of spread. This is a B or maybe Ba/BB type level of credit risk. Typically, the kind of fund you are contemplating uses leverage and buys bank loans made to companies with junk ratings, meaning that there is little interest rate risk, but a lot of credit risk.

Basically, you pays your money and you takes your chances. I personally am not interested in taking interest rate risk. I am willing to take credit risk if the money is managed by someone who is good at credit analysis.
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Re: Closed-End Muni Fund
Old 07-28-2005, 03:28 PM   #10
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Re: Closed-End Muni Fund

It always amazes me to find out how much I don't know!

I definitely understand that duration measures interest rate sensativity, but where/how did you use duration when calculating the 500 bp spread?
How do you go about avoiding interest rate risk completely (as you mention in your post)? Obviously this is an attractive thing to do in the current environment. Would I have to use some sort of hedging instrument?
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Re: Closed-End Muni Fund
Old 07-28-2005, 03:33 PM   #11
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Re: Closed-End Muni Fund

Quote:
Originally Posted by dandan14
It always amazes me to find out how much I don't know!

I definitely understand that duration measures interest rate sensativity, but where/how did you use duration when calculating the 500 bp spread?
How do you go about avoiding interest rate risk completely (as you mention in your post)?* Obviously this is an attractive thing to do in the current environment.* Would I have to use some sort of hedging instrument?*
To get the spread, you just take the yield on a given instrument and subtract the relevant treasury or LIBOR rate. In this instance, I see that the yield is 8% and the duration is 2. Treasuries with similar duration yield about 4%. I actually made an error initially: The spread is actually 400BP (8% - 4% = 4% AKA 400BP).

I don't avoid interest rate risk completely (that would be hard to do). Instead, I avoid buying anything with a duration of greater than 4 or 5. That's a modest amount of interest rate risk, so you won't be completely clobbered in the event of a rate shift. If you want to avoid excessive rate risk, just stay in things without too much duraton. IIRC, the Lehman Agg has a duration of roughly 4 and change.
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