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May 3, 2004, 12:01 a.m. EDT

Stay Open to Closed-Ends

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By Lawrence C. Strauss

Scoreboard | Fund Scope | Cash Track

IT'S BEEN A NASTY STRETCH LATELY for closed-end bond funds, particularly those that use leverage. The main culprit: the specter of rising interest rates.

From April 2, when those fears were sparked by the strong March employment report, to April 23, the net asset value (NAV) of U.S.-based closed-end bond funds fell nearly 1%, on average, according to Lipper, the fund-tracking arm of Reuters. More telling was that the market prices of those funds dropped 7.6% over that period. "You had everyone going out the door at the same time," says Thomas J. Herzfeld, president of Thomas J. Herzfeld Advisors, a closed-end shop in Miami.

Closed-end funds, which issue a limited number of shares that trade on an exchange, can use leverage, or borrowing, to boost their returns, and this strategy has worked particularly well in the low-rate environment brought about by Federal Reserve Chairman Alan Greenspan. These funds borrow money at short-term rates and invest in longer-term securities, playing the spread. But that spread gets squeezed when rates rise.

As expected, these funds have performed well over the last few years, notching a three-year annualized return of 6.62%, on average. The strong relative returns attracted a lot of new capital. From January 2001 through July 2003, initial public offerings raised $38.6 billion in income-related funds, according to Lipper. By way of comparison, domestic closed-end bond funds total about $133.2 billion in assets.

A number of investment pros who follow this sector, however, sense some value, insisting the selloff is overdone.

"In many cases, I think it is a good buying opportunity because discounts have widened to very attractive levels that are deeper than historical norms," says Jeffrey Margolin, a closed-end fund analyst at Ryan Beck. "But you need to pick your spots carefully."

Last September, Margolin downgraded closed-end leveraged municipal-bond funds, which posted double-digit returns in 2000, 2001 and 2002. "We are concerned that over the next 12 to 18 months, as the economy continues to show signs of improvement and investors begin to worry about rising short and long-term interest rates, they will begin to sell their long-duration, leveraged municipal closed-end funds," Margolin wrote last September.

True, he made his call too early, but he was onto something.

"If interest rates continue to rise on the long end and start to rise on the short end, leveraged municipal funds will be one of the hardest-hit sectors in closed-end funds," Margolin told Barron's last week. "In 1994 and 1999, when rates moved up, leveraged municipal funds were down 20%, on average."

William Adams, executive vice president of the US Fund Products Group at Nuveen Investments, a major player in closed-end funds, says the recent selloff "is in our view part of the normal cycle you see in the interest-rate markets." Nuveen launched its first closed-end municipal fund, Nuveen Municipal Value, in 1987, followed by Nuveen Premium Income Municipal, which uses leverage, in 1988.

While Margolin is taking a selective approach, Herzfeld, a well-known follower of closed-end funds, sees short-term opportunities across the board.

"We're buying the whole basket of the closed-end end universe that has been depressed because of fears of rising interest rates," says Herzfeld.

He concedes that the notion of a long-term rise in rates is "a very sound argument."

"Long-term, you can make a pretty bearish case for both NAVs and share prices of bond funds or any interest rate-sensitive closed-end fund," he continues. "But my point is not that these are great long-term buys. They've been hammered to the widest discounts in two years."

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