Muni CEFs -- an Update

A while ago, I made Muni CEFs the stock of the month for October. The original post can be reached by clicking on the title to this post. In short, the basis for my selection was the likelihood of continuing low short term rates that allow the CEFs to make major profits on the spread as well as the disparity between the return on tax free municipal bonds and taxable treasuries or corporate bonds. Since then, the Muni CEFs have done fine, but in the last three days, there has been a major movement in their prices. Two days ago, the group fell by percentages of 1 to 2%. Then yesterday, the stock continued to fall. Today, they are bouncing back to the up side. So with this extraordinary movement for these investments, the question arises as to what to do with them now. My answer is to hold on for now.

First, it is important to remember that the bond markets were closed yesterday for Veterans Day. That means that yesterday's movement was not reflective of the value of the municipal bonds themselves, but rather reflected stock market forces that were pushing down the premiums of most of the CEFs (or increasing the discounts). In fact, the combination of the recent declines has for the most part been due to a change from premiums to discounts. In other words, the market price of the average CEF was, as of yesterday's close, less than the net asst value per share for the CEF. This fact helps to provide a floor under the stock price. For example, I bought shares in a CEF this morning that was selling at discount of over 9% to the NAV. Since then, the stock price has bounced back up to bring it back towards the NAV. Over the long term, the stock price and the NAV have to move towards each other, so buying discounted CEFs is a good way to help increase the yield for these securities.

Second, some of the volatility in the muni market must be due to the start of QE2. It seems that the Fed is not only injecting money into the money supply but it is also injecting fear into the markets. Fear of higher interest rates and inflation are bad for the municipal bond market. In my opinion, the recent decline in munis is due, in part, to this additional fear. Thank you, Ben Bernanke!

Once things quiet down, the basic economics of the muni CEFs should reassert itself. While these investments need to be watched, I recommend that you stay with them.

Disclosure: As I mentioned above, I am long Muni CEFs.