Stock of the Month for October -- Muni CEFS

This month's selection as stock of the month is a whole class of stocks, namely Closed End funds for Municipal Bonds or Muni CEFs as they are known. These are companies that own a portfolio of municipal bonds. their holdings are leveraged with the companies raising capital through short term borrowing as well as through stock sales. The shares of the Muni Cef trade on the open market, so their value is not set by their net asset value alone. Depending on market conditions, the muni cefs trade at a premium or discount to their current net asset values.

At the moment, short term rates are extremely low, and they are likely to stay there for quite some time. The Fed has indicated pretty clearly that we will not see a rise in short term rates during the next six months and maybe for substantially longer. This gives the Muni Cefs the ability to borrow at very low cost and then to buy muni bonds that pay a tax free yield substantially higher than their cost of money. This allows the CEFs to pay a yield that is much higher than a traditional muni bond. For example, Invesco Van Kampfen Municipal opportunity Trust (symbol VMO) is currently yielding 7.12%. This 7.12% is free of all federal income tax -- provided one is not subject to the Alternative Minimum Income tax. (16.5% of VMO's payout is subject to the AMT). Roughly 10% of the bonds owned by VMO are unrated and of the remaining 90%, all but 1.5% is rated as investment grade. As of yesterday's close, the VMO stock was selling at about a 3% premium to the underlying net asset value.

What all this means is that most folks can get a tax free yield of about 7 and one-eighth percent the should be relatively stable for the next six months at least. Unless there are wholesale defaults by issuers of municipal bonds, a significant rise in shrt term interest rates or a significant rise in long term rates (which is also very unlikely in the next six months), these muni cefs should pay a rather hefty after tax yield with a fair amount of safety that the principal will not decrease. Indeed, if the Democrats never get around to extending the Bush tax cuts, the value of this tax free income stream may increase dramatically. That alone could lead to a marked rise in the price of the stock.

Other Muni CEFs that I would recommend are MHI, VGM, VKI and NMD. Not all have as high quality holdings as VMO, so you should investigate their holdings and yields before buying. A good place to find this information is at a site called CEF Connect. it can be reached by clicking on the title to this post.