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Could Muni Bonds Be Exciting?

Some closed-end muni bond funds could hold promise should interest rates fall.

Interest rates may finally be cresting, in the view of some economy watchers. For instance, economists at Friedman, Billings, Ramsey Co. predict that yields on two- and ten-year Treasury notes will start tumbling this quarter, and continue falling into next year. That's good news for bond investors, who have been suffering as yields have risen (bond prices move inversely with interest rates). How to play the market turnaround?

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Mariana Bush, an analyst for Richmond, Va.-headquartered Wachovia Securities, thinks closed-end municipal bond funds make a fine investment. Closed-end funds differ from open-end funds in that they issue a fixed number of shares and trade on exchanges like stocks. The share prices and net asset values of closed-ends often diverge. That often allows investors to invest in closed-ends at discounts to the value of the securities they contain. And most fixed-income closed-end funds employ leverage, which enhances potential yield if you guess correctly about the direction of interest rates, but also raises volatility and the potential for losses.

Bush, who is based in Washington, D.C., notes that most closed-end muni funds are currently trading at a large discount to net asset value (NAV). For instance, the average leveraged, intermediate-maturity muni closed-end fund currently trades at a 6% discount to net asset value. If you buy a closed-end at a discount and interest rates indeed fall, you could be looking at a handsome gain.

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Here are some of Bush's picks. Among national muni funds stuffed with AA-rated bonds, she likes Van Kampen Trust for Investment Grade Municipals (symbol VGM, $14.42) and Nuveen Premium Income Muni Fund 4 (NPT, $12.41). Both currently yield 5.3%. That's the equivalent of 8.2% from a taxable bond for someone in the 35% federal tax bracket. The Nuveen fund sells at a 7% discount to NAV and Van Kampen at a 13% discount. If you're looking for a slightly higher yield, you can find it in Putnam High Yield Muni Trust (PYM, $6.84), which holds a portfolio of BBB-rated municipal bonds and trades at a 13% discount. If leverage terrifies you, consider Municipal High Income Fund (MHF, $7.47), a non-leveraged, high yield fund that pays out 5.5% and sells for 8% less than net asset value.

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