(Bloomberg) -- Municipal bond funds that use borrowing as a way to juice returns had a banner month in November, surging almost 12%. Some market watchers say that’s only just the start.

Leveraged closed-end muni funds rallied along with the broader market as evidence of slowing job growth and cooling inflation convinced traders that the Federal Reserve’s rate-rise cycle is over. Further gains may be in store should the central bank pivot to cutting rates next next year, as many now expect. 

But there’s more to the story. Despite last month’ gains, leveraged closed-end muni funds are still trading at steep discounts to their net asset value. In the past, this has set them up for a market-beating performance. Taken together, these conditions — combined with the arrival of activist investors looking to push measures that would boost funds’ share value — paint a bullish picture for the sector.

“The backdrop for the closed-end fund muni space is the best I’ve seen in my career,” said Ryan Paylor, a portfolio manager at Miami-based fund manager Thomas J. Herzfeld Advisors, which owns stakes in 21 muni closed-end funds. He predicts fund returns of as much as 20% in 2024.

Closed-end funds raise a fixed amount of money from shareholders in a public offering, unlike mutual funds, which continually sell and redeem shares. The funds are listed on stock exchanges and can trade at premiums or discounts to the net value of the securities they own. Most muni closed-end funds use leverage so they can pay higher distributions — and make more fees. 

These funds are currently trading at a historically wide average discount to net asset value of 12.3%, Thomas J. Herzfeld Advisors’ data shows. That’s a reflection of market losses earlier in the year from which these funds have yet to fully recover.

Even after November’s rebound, leveraged muni closed-end funds are trading at discounts that have occurred just 1% of the time over the last 20 years, according to BlackRock Inc. Buying into these funds at times like this has proved rewarding in the past, research from the investment giant shows.

During four annual periods when discounts exceeded 11%, municipal closed-end funds have outperformed a broad municipal bond index by an average 14.2 percentage points. Three of the four periods coincided with Fed rate cuts. This year, discounts hit 11% or greater on March 14, according to BlackRock.

Muni closed-end funds may still be on sale because retail investors, who make up the largest segment of the muni closed-end fund buyer base, are licking their wounds from losses, said Paylor. The Fed’s aggressive campaign of policy tightening battered bond prices and led many funds to cut distributions. In addition, tax-loss selling in recent months put pressure on share prices. The $224.5 million VanEck CEF Muni Income ETF, which seeks to track the performance of a muni bond closed-end fund index, lost 24% last year including reinvested dividends, and is up just 1% this year.

The funds’ steep discounts have started to attract activist investors like Saba Capital Management and Bulldog Investors. Activist funds declared 100 stakes of 5% or more in at least 61 closed-end funds as of Dec. 4, according to Paylor.

‘Open-Ending’

Paylor expects activist shareholders to push for tender offers or liquidations to boost share prices and narrow discounts. Liquidation, ”open-ending,” — the practice of turning a closed-end fund into an open-end fund — or a tender for shares may allow investors to exit positions at little or no discount.

An investor who buys a fund with a 15% discount that liquidates or converts into an open-end fund would get an 18% return even before factoring in the yield or potential gains in net asset value, he said. 

UBS Global Wealth Management is more cautious on the sector. 

With short-term municipal borrowing rates at 3.3%, the cost of leverage used by the funds is still high, said Sangeeta Marfatia, senior closed-end fund strategist at UBS GWM. Although valuations look attractive, some leveraged muni closed-end funds from BlackRock, Nuveen LLC and Pacific Investment Management Co. aren’t earning enough from underlying holdings to pay distributions. That means money to pay unsustainable dividends comes from fund assets, eroding the funds’ future earning power. 

“When you return capital, that’s really not good long term for the shareholder,” said Marfatia. 

UBS GWM expects the Fed to cut interest rates by half a percentage point in the second half of 2024, which would improve closed-end funds’ earnings. For discounts to close, though, share prices will have go up 10% to 15% more than the net asset value of the funds’ bonds, according to Marfatia. “I don’t see that happening,” she said. 

In the near term, investors have an opportunity to take advantage of temporary mispricing of the closed-end fund market, BlackRock said. Closed-end fund discounts tend to narrow in January, when investors get back into the market to rebalance portfolios after tax-loss sales. The pent-up demand, known as the “January Effect,” can drive outperformance, BlackRock said. 

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