Muni Funds That Use Borrowed Money Take a Big Hit

livemint.com:

Some municipal-bond funds are suffering their worst stretch since the 2008-09 financial crisis, an acute example of how two years of rising interest rates have slammed investors’ portfolios. Closed-end municipal-bond funds have been particularly hard-hit because they often use borrowed money to invest in fixed-rate, long-term bonds sold by state and local governments. The leverage helps boost the returns from debt that is ultrasafe, but pays relatively little interest.

That worked for much of the past decade until rates started rising. Now, short-term borrowing is becoming more expensive while the market value of older, lower-yielding bonds in the mutual funds is falling. The structure of these funds is also working against them.

Unlike with traditional, open-end mutual funds, closed-end fund investors can’t easily cash out their shares, and managers can’t sell additional shares. Instead, investors trade closed-end funds shares between themselves. Managers therefore generally have little cash to add newer, higher- yielding bonds that would make the funds more appealing to today’s investors.

“Munis have this double whammy," said Sangeeta Marfatia, senior closed-end fund strategist at UBS. “Their borrowing costs have gone up, their underlying bonds have gone down, and the combination of that is what’s crushing them." Fallout from higher rates has hit stocks, home purchases and capital investment by big companies. Before last year, bond prices had never declined for two years in a row in the history of the Bloomberg U.S.