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Closed-end municipal bond funds pay high yields

- Alan Lavine and Gail Liberman

Investing in tax-free bonds isn't as safe as it used to be. States are running big budget deficits. And if interest rates rise, bond prices will fall.

So what should you do?

Rodger Conrad, analyst and associate editor of Personal Finance, a McLean, Va.-based newsletter, says you have to invest in the financially strongest municipal bond issuers rated AAA and Aaa by Standard & Poor's and Moody's, respectively. You also need to own a large number of bonds in a large number of states.

It takes a mountain of cash to own a large number of individual municipal bonds. So another alternative, he suggests, is to invest in closed-end municipal bond funds. Closed-end bond funds sell a fixed number of shares that are traded on the stock exchange. So you essentially own stock in a company that owns a basket of bonds.

Closed-end funds have two share prices. The stock price of the fund that is traded on the stock exchange and the net asset value of the securities managed by the fund.

Today, closed-end municipal bond fundsí share prices are 3 percent less than their net asset values. In other words, you are essentially buying the investment for 97 cents on the dollar.

This sounds like a tremendous bargain. However, closed-end bond funds are not risk-free. The stock price could drop due to bad news about local and state economies. Rapidly rising interest also could trigger losses.

The most conservative closed-end municipal bond fund he recommends is the Black Rock Muni Target Term Trust (BMN). The closed-end fund will terminate and pay investors off in 2006 at an expected value of $10 per share. The fund sells at a 2 percent discount from its net asset value, and yields 5.2 percent tax-free. Someone in the highest tax bracket would earn a taxable equivalent yield of 8.26 percent.

Conrad recommends that you only pay up to $11 per share for the fund. The reason: the share price will gradually drop to $10 when the trust terminates and the shareholders are paid off. However, the tax-free income received from the fund will offset the share price decline. Overall, he estimates that annual tax adjusted return on the fund will be in range of 5 percent to 6 percent.

"With less than four years to maturity, it has very low exposure to interest rates swings," Conrad says. "Credit risk is controlled by the fact that 99 percent of the securities are rated AAA and issuers are scattered over a range of states."

Conrad expects the fund's yield to remain fairly stable. The reason: 89 percent of the fund's holdings are locked in at higher rates.


Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).

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