Closed-end municipal bond funds continue to enjoy shelter from the turbulence plaguing the rest of the sector.

Closed-end funds devoted to stocks, bank loans, or taxable bonds have taken a wild ride this year.

The First Trust Advisors index tracking CEFs that invest in stocks is down 9% this year, and at one point was up as much as 6%.

The index following the entire closed-end fund universe is down 2.3% and was up as much as 6.4% earlier in the year.

It’s a different story for municipal closed-end funds.

The First Trust municipal CEF index is up 5.9% for the year and has not spent a day in 2010 in negative territory.

The index climbed every month in the first half except May, when it slipped all of 0.09%.

Sangeeta Marfatia, a closed-end fund analyst with UBS Wealth Management, said the stability of the municipal closed-end fund space is a function of the steady performance in the state and local government debt underlying the funds.

For all the hand-wringing over a meltdown among sub-sovereign U.S. governments, municipal bonds notched a wonderful first half.

The S&P AMT-Free National Municipal Bond Total Return Index is up 3.74% in 2010, and the yield on the benchmark 10-year triple-A rated muni bond is under 3%, based on the Municipal Market Advisors scale.

As long as the bonds themselves are hanging in, Marfatia said, people continue to feel comfortable holding closed-end municipal bond funds.

“The muni market’s still holding up,” she said. “Muni funds are up because the underlying muni market is still stable.”

It does not hurt that many municipal CEFs are paying fat dividends at a time when dependable income is difficult to find, she said.

Nuveen Investments — the biggest muni closed-end fund manager with about 100 funds that hold more than $24 billion in net assets — raised dividends on about half its municipal funds last month. Many of them yield more than 6% tax-free at a time when even single-A rated 30-year muni debt does not breach 5%, according to Municipal Market Data.

The 97 components of the First Trust municipal closed-end fund index offer a weighted-average tax-free yield of 6.34% — which to an investor in the 35% tax bracket would equate to a taxable yield of 9.75%.

Municipal bond closed-end funds are investment vehicles that offer investors leveraged exposure to state and local government debt.

A closed-end fund typically raises money by selling shares in a trust to investors. The trust then uses the cash raised to buy municipal bonds, and pays monthly dividends to investors with the income earned on the trust.

What distinguishes a closed-end fund from an exchange-traded fund or a mutual fund is an ability to employ leverage. CEFs typically borrow additional money by selling short-term debt and use that borrowed money to buy additional bonds. The extra income in excess of the trust’s cost of debt is gravy for shareholders.

Take, for example, the Nuveen Premium Income Municipal Fund 2, which is the fourth-biggest municipal closed-end fund.

The fund manages $1.53 billion of municipal debt, from such names as California, Florida, and Illinois.

The Premium Income Fund has $1.04 billion in equity from shareholders. The remaining $487.5 million was raised by selling preferred shares. The idea is the fund will collect more in interest on the bonds than it will pay on its preferred shares.

The bonds in the fund’s trust pay an average coupon of 4.84%. The fund is only paying 0.35% in interest on its preferred shares.

Borrowing money thus enables a trust with an average coupon of less than 5% to sport a dividend yield of 6.32%.

Closed-end funds owned $82 billion of municipal debt at the end of the first quarter, according to the Federal Reserve — about 2.9% of all outstanding municipal bonds.

Alex Reiss, a closed-end fund analyst with Stifel Nicolaus & Co., has warned repeatedly over the past months that municipal closed-end funds are not bonds — they are stocks and they threaten investors with stock-like risks.

When volatility kicks in and people get scared, Reiss said, one can expect municipal CEFs to sell off, too.

So far it has not happened.

Muni bond closed-end funds have delivered a 9.2% return already this year, vastly outperforming other closed-end fund sectors. And they have delivered these returns with significantly less volatility.

The First Trust municipal closed-end fund index has exhibited volatility — meaning standard deviation in price changes — of just 5.3% this year. In comparison, the composite closed-end fund index’s volatility is more than 13% this year.

The sector’s performance this year says nothing about whether the funds are worth buying now.

CEF investing often concerns discounts and premiums. Because these funds trade publicly on exchanges and frequently employ leverage, the value of the shares usually deviates from the value of the assets in the trust.

Investors in closed-end funds often like to buy a fund’s shares when they are trading at a meaningful discount to the fund’s assets.

In late 2008, these were easy to find. At one point in October of that year, the 10 biggest municipal closed-end funds traded at an average discount of nearly 20%. Five of the 10 biggest funds traded at discounts of more than 30%.

Since then, the sector has rallied 67% and substantial discounts are much harder to find.

The 10 biggest municipal closed-end funds now trade at an average premium of more than 1%.

Of the 97 component funds in the First Trust municipal closed-end fund index, 55 trade at a premium. The $485.5 million Pimco Municipal Income Fund trades at a premium of more than 20%. The $37.2 million BlackRock Virginia Municipal Bond Trust is trading at a premium of 22.7%.

Reiss pointed out that the premium on BlackRock’s Virginia fund means the trust’s assets would have to return 6.33% annually just to maintain its dividend yield.

By comparison, only 33 of the more than 160 component funds in the First Trust equity closed-end fund index trade at a premium.

In its monthly report, Thomas J. Herzfeld Advisors wrote that municipal closed-end funds are in an ideal environment.

Interest rates are low, leaving investors starved for yield. The debt the funds rely on for leverage are typically tied to short-term benchmark rates such as the London Interbank Offered Rate, which despite a recent spike remains well under 1%. That allows CEFs to extract significant additional yield from their leverage.

“Municipal closed-end funds have been among the greatest beneficiaries of investor interest, and they continue to do an amazing job in terms of both capital appreciation and the ability to generate increasingly attractive income,” Herzfeld wrote.

The problem, Herzfeld said, is that the municipal closed-end funds’ leverage structures are not secret.

Investors looking for plump dividends have been buying these funds for months, rendering them expensive.

With the average municipal closed-end fund trading at a premium, many funds are “too pricey” for the firm’s strategy, which emphasizes buying at a discount.

Herzfeld has a sell rating on most of the municipal CEF universe.

Marfatia also considers the space too expensive.

“I think you don’t buy them here,” she said. “They are very expensive. ... It could be vulnerable from rich valuations a little bit.”

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