default risk of municipal bonds

Just how many defaults exactly will occur, is open to question, your guess could be better or worse than the market.

Be sure to understand how the closed-end fund uses leverage. The "auction rate securities" that are in the news include preferreds of Municipal-fund CEFs. When those auctions break down and the interest rate is set at 10%, 12%, etc instead of something like 2%, the CEF is losing money on the leveraged part of the portfolio. CEF leverage is premised on borrowing at low short-term rates and investing at (only slightly higher) long-term rates.

That said I was seeing CEFs recently that looked as if they were priced for "a Madoff investor or hedge fund needed to sell to raise cash" or some similar "liquidity event", rather than risk related to leverage. That's an unknown and a risk factor though. Before buying it would be a good idea to investigate whether there are "blow-up" scenarios specific to a CEF - its use of leverage, its reliance on the auction-rate market, etc. The CEF structure provides some protection because you don't have the risk of mass redemptions that you do with an open-ended mutual fund. But I haven't looked at many specific muni CEFs and it's possible the CEF pricing reflects true risks rather than just "no buyers."

Regarding muni defaults, your main question - while I'm tempted to fall back on "unless taxes permanently go away, munis always have a fall-back source of revenue" I could see a cash crisis on a macro level resulting in suspended interest and principal payments - IOUs for your IOUs. Why not? CA state employees might not be paid this month so anything is possible. And there's the risk of hits to principal if the market is flooded with new issues, to fund deficit spending by states and municipalities. I also think that such an event would be driven largely by fiscal mismanagement on the part of the elected officials. CA being an excellent example of this at the moment.

-Tad

But it's not. According to Bloomberg the 30 year treasury is yielding 3.75% and

But I don't think it is fear of default that is driving that. Historically, defaults have been extremely low. 0.07% for investment grade muni ratings, not just the AAA we are talking about.

Many investment houses sold munis because they needed liquidity and munis were easy to sell. There was an unusually high number of new issues last year, according to Morningstar, which drove the yield up. Also flight to quality drove treasuries down. So I think that there is an unusual opportunity to buy munis for both a nice yield and some capital gains.

This Morningstar article makes the case:

-- Doug

Thanks for your comments. Closed end funds cannot pay dividends if their NAV falls so far that they exceed 2-1 leverage. When that happens, the CEF suspends common dividends until enough auction rate preferred securities (ARPS) have been redeemed to get the leverage under 2-1. Many CEF investors are irrational individuals who just look at the dividend, and when the dividend is cut, some will sell at absurd prices. Schedules of ARPS redemptions are posted at CEF web sites, and if one does some analysis and buys soon before the common dividends are resumed, one can make money. One CEF where this occurred is Nicholas-Applegate Convertible & Income Fund II, symbol NCZ.

I figured you of all people had already dug into this and were aware of the issue. Agree with your premise that CEFs may have unique opportunities because of who owns them, and why, so it might be a matter of doing the homework - and having that done when the buying opportunity crops up.

I'm aware of one muni CEF that had a recent few-day window where the price represented a 9% tax-exempt yield. It since has gained over 40% in value (and is still at a discount, and a yield far above comparable Treasuries). It's entirely possible the shoe just hasn't dropped yet and something is still amiss with its ARPS (though not the bonds, which are priced just fine). But so far it has the appearance of "too many sellers," in what is at the end of the day a somewhat illiquid part of the market.

When you think about it, by definition most muni CEF investors should be higher-income individuals. If that category of individuals faced abnormally high "liquidity needs" it makes sense that you might find some odd pricing in the things they invest in. Just a theory of course!

-Tad

Some cities are in desperate financial shape, but its not clear which ones are. The Forbes article on "gilt-edged" public em[ployee pensions said the Vallejo bankruptcy was triggered by a double than normal number of public employees retiring and taking lump sums. Chicago's pension system is just 19% funded. Most pension funds report on a June fiscal year, so we'll be hearing things in the summer.