It's not only tough from an emotional perspective to see one of
our great cities, Detroit, go bankrupt, but the disaster has also
caused a lot of pain in the municipal bond market where investors
are selling on fears that other cities around the country will
But putting sympathies for Motor City aside, there may be a trade
in this situation for intrepid investors.
All the fears about municipal bond defaults have closed-end
municipal bond funds trading at steep discounts. That makes many of
them potential buys on the assumption that all the fears ease to
some degree over the next several weeks or months.
"The recent pressure on share prices is presenting an opportunity
to buy some well-managed funds at attractive discounts," says
Cecilia Gondor at Thomas J. Herzfeld Advisors, which specializes in
closed-end funds. "We like muni funds as short-term trades."
Meanwhile, you also stand a chance to get a 5%-6% annualized
tax-free yield if you hold them long enough (they typically pay out
Closed-end funds are similar to mutual funds except for the fact
that they raise investment capital in one-off shots, as opposed to
getting fresh money (or redemptions) daily from investors, and
their shares trade throughout the day.
Let's be clear: Discounted closed-end municipal bond funds may only
be a short-term trade on a near-term reduction in fears about
municipal defaults. The reason: We are probably moving into an
ongoing rising interest rate environment here, which will continue
to put downward pressure on virtually all bond prices.
In the interim, though, meaning over the next several weeks or
months, fears about municipal bonds could ease enough to make these
closed-end funds rebound nicely.
"Closed-end fund investors tend to overreact to disasters, so share
prices decline more quickly than underlying net asset values," says
Gondor. Net asset value (
) is the actual value of the underlying holdings in the fund. The
"discount" refers to the difference between the market cap of the
closed-end fund, and the NAV. "This inefficiency provides
attractive investment opportunities when the discount become
unusually wide. As things calm down, net asset values typically
stabilize or recover and discount levels narrow."
Here's a list of the best potential trading vehicles in the
municipal bond closed-end fund space, according to Gondor. The
first two percentages following the fund name are the average fund
discount to NAV over the past year, and the current discount to
NAV, respectively. Looking for the widest gap between the historic
discount (the first percentage) and the current discount (the
second percentage) leads you to the better potential trades, as
opposed to just buying funds with big discounts. The reason:
Closed-end funds often trade at a discount to NAV, so it's the size
of the discount compared to a fund's historic discount that
matters. The third percentage after the fund name is the annualized
yield. All percentages are as of the close of trading August 12.
Nuveen Dividend Advantage Municipal Income Fund
(NYSEMKT:NVG) -6.6%; -13.8%; 5.33%
Nuveen Dividend Advantage Municipal Fund 3
(NYSEMKT:NZF) -6.2%; -13.8%; 5.73%
Nuveen Quality Income Municipal Fund
) -5.2%; -12.1%; 6.33%
Delaware Investments National Municipal Income
(NYSEMKT:VFL) -5.6%; -12.1%; 6.16%
BlackRock Municipal Income Investment Quality
) -3.4%; -11.6%; 6.54%
All of these funds are leveraged, which means managers have
borrowed money to invest. That should give these funds extra spring
in any rebound caused by a reduction in fears about muni bond
defaults. It also means that these funds would fall more than
unleveraged funds, if fears get worse. In short, leveraged funds
are more volatile.
Will the fears about muni bonds get worse? No one knows for sure.
But I'm going to guess that while a lot of cities have trouble with
budgets that are out of balance, given all their borrowing and all
the pension promises to city employees, we might not see another
major Detroit style announcement any time soon.
One possible turning point to watch involves a pending court
decision in Michigan on Detroit, where pensioners and municipal
bond investors are fighting over who should take more losses in the
bankruptcy reorganization. If the decision favors pensioners,
"expect to see some broad fallout in the municipal market, even for
financially strong cities and states," says Fred Dickson a market
strategist with the brokerage D.A. Davidson & Co.
Michael Brush is an award-winning New York-based financial
journalist who writes a weekly stock market column for MSN Money
and is the editor of
Brush Up on Stocks
, an investment newsletter. Michael has covered business and
investing for the
New York Times
, the Economist Group, and
magazine. He studied at Columbia Business School in the
Knight-Bagehot Fellowship program. He is the author of
Lessons From the Front Line
, a book offering insights on investing and the markets based
on the experiences of professional money managers.