Municipal closed-end funds continue to surge to new peaks despite the specter of higher interest rates threatening to throw a wet blanket on all the fun.

After returning 43% last year, closed-end muni funds have delivered an additional 5.6% already this year, according to a First Trust Advisors index tracking the sector.

The index touched its all-time high on Wednesday.

The ascent is fueled by an interest-rate complexion ideal for closed-end funds.

Borrowing costs are low and the yield curve is steep.

The same factors that make municipal CEFs attractive in this environment, though, also make them more susceptible to a shift in interest rates.

"Very vulnerable" was Relative Value Partners' chief investment officer Maury Fertig's response when asked how vulnerable municipal closed-end funds are to increasing interest rates.

"They basically live off the fact that there's a very, very steep curve right now," Fertig said.

When the Federal Reserve indicates it is ready to hike its target for short-term rates, Fertig said "you'll probably have a really bad day in muni closed-end funds."

While Fertig has been trimming his positions, he pointed out municipal CEFs still have a lot going for them.

Most have been raising their dividends and continue to build up cash that will likely translate into higher dividends down the line, he said.

And while higher interest rates would damage the sector, rates would have to rise quite a bit to render leveraged closed-end funds worse off than plainer municipal vehicles that do not utilize leverage.

The municipal closed-end fund industry according to the Investment Company Institute, managed $77.9 billion at the end of last year.

A municipal CEF raises cash from investors by selling shares in a trust. The trust uses that cash to buy a basket of municipal bonds.

Many trusts also borrow money and use it to buy additional municipal bonds.

By collecting more in coupon payments on the municipals than they pay on the borrowings, closed-end funds juice returns to shareholders using leverage.

The Federal Reserve has maintained a short-term interest rate target essentially at zero for more than a year. This target has been a boon to most of the fixed-income universe, but it has been especially helpful to closed-end funds.

Why? Low interest rates have fortified the values of the bonds closed-end funds hold, just like any portfolio of bonds.

Low interest rates have also enabled funds to pay negligible interest on their short-term borrowings.

Most leveraged closed-end funds pay interest rates tied to the London Interbank Offered Rate or some other short-term benchmark. The benchmarks are extremely low right now.

Nuveen Investments, the biggest closed-end muni fund manager with more than 100 funds totaling $34.9 billion in assets, is paying 0.4% interest on some of its leveraged funds' borrowings.

Van Kampen Investments, which runs a dozen muni CEFs with $6 billion in assets, is paying as little as 0.16% on some of its funds' borrowings.

By borrowing money at far lower rates than they collect on municipal bonds, many closed-end funds are offering tax-free yields of more than 7%. That kind of yield is hard to find today on long-term junk bonds, let alone on investment-grade state and local government debt.

While any bond investor shudders at the thought of higher interest rates, municipal closed-end funds face additional layers of interest rate risk.

They face normal duration risk, or the decline in value the bonds would suffer should long-term interest rates rise. They also face higher borrowing costs because of the ascension in the benchmark rates that form the basis for the rates paid on CEFs' borrowings.

An increase in interest rates would decrease the value of closed-end funds' bonds and squeeze the spread between coupons on municipal bonds and rates paid on borrowings.

Jeff Margolin, a CEF analyst with First Trust, said the question he has been getting the most lately is how to invest in a rising interest rate environment.

"We've seen indications that investors are already nervous about how funds may react when short-term interest rates begin to rise," Thomas J. Herzfeld Advisors wrote in its monthly report.

They have not begun to rise yet. The Fed has been careful to retain the "extended period" phrase describing its time horizon for keeping rates low.

Nuveen has accelerated its efforts to hedge a little against higher interest rates by restructuring its leverage. Closed-end funds typically pay floating rates on their debt, meaning when rates go up borrowing costs will go up along with them.

Nuveen has been redeeming its floating-rate securities and replacing them with debt on which it is paying rates closer to 3%. Nuveen announced nearly $1.3 billion in new redemptions of its floating-rate preferred shares in March, bringing the total to $4.3 billion.

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