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A Pro Who's Mad For Munis


From his desk at PIMCO's Newport Beach (Calif.) headquarters, Bill Gross oversees some $500 billion of other people's money -- slightly less than the gross domestic product of Thailand. What is this master of the universe doing with his own money? Municipal bonds in general, but closed-end muni bond funds in particular. "I own 35 of these funds personally," says Gross. "You can get a 6% yield on some of these tax-free, compared to just 4% on Treasury bonds. That's a great deal."

It could well be. But Gross's strategy is rife with risk. These funds invest mainly in long-term bonds, and increased tightening by the Fed or a surge in inflation could send prices reeling. That would be especially hard on funds that borrow money to buy additional bonds to juice their yields, a strategy called "leveraging." On top of that, the funds are not cheap. In fact, many trade (closed-end funds are bought and sold like stocks, not like mutual funds) at prices higher than their net asset values (NAV is the market value of a fund's portfolio divided by outstanding shares).

Most analysts who specialize in closed-ends recommend buying only when they trade below their NAVs. "The last time we saw wide discounts on muni funds was at the end of 1999, when no one wanted to own bonds," says Paul Mazzilli, director of exchange-traded fund research at Morgan Stanley. () "Today the average discount is only 1.4%, vs. a 3.6% average for the past 10 years." No doubt Gross bought many shares at discounts, but he continues to hold those now at premiums.

To embrace Gross's strategy is to believe that the Federal Reserve will soon ease up. "We've already had 15 months of steady increases, which is the average tightening cycle," says the bond maven. He also argues that the rate hikes are aimed at cooling the overheated housing market, and that's happening.

BUILD A BUY LIST

What if the Fed continues to hike rates? Higher short-term rates will destroy the ability of leveraged funds to maintain their dividends. "We're already seeing waves of payout cuts in these funds," says Mazzilli. "And when the funds cut, their shares get whacked."

Mazzilli is wary of most closed-end muni funds, but he does have a few favorites. Among them is Managed Municipals Portfolio, which sells Treasuries short to hedge its munis, and has an 8.4% discount. Two others, Muni Intermediate Duration Fund and Nuveen Quality Income Municipal Fund, are also at discounts. In contrast, two of Gross's holdings, BlackRock Municipal Income Trust II and PIMCO Municipal Income Fund, () both trade at premiums, in part, some speculate, because Gross owns them.

Perhaps the best strategy is to build a buy list. Thomas Herzfeld of Thomas J. Herzfeld Advisors, which invests solely in closed-ends, says they usually get cheaper near yearend as investors engage in tax-loss selling. While the funds' leverage, fees, yield, and holdings are important, the discount is paramount. "The size of the discount is about half of our decision-making process," he says. By that standard about 10 funds are attractive now. But if you keep your eyes open, discounts should open up on many more. Who knows? By yearend the Fed may be done with its rate hikes -- and Gross will have been proved right.

By Lewis Braham


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