(FORTUNE Magazine) – Fixed-income investors looking for juiced-up yields have been finding them lately in closed-end municipal bond funds. According to fund tracker Lipper, closed-end munis cranked out an average return of 9.2% in 2003--not too shabby considering the average yield on a ten-year Treasury note stood at about 4%. Investors, not surprisingly, have been piling into the funds in droves. Some $13 billion has been poured into funds offered by firms like Dreyfus, Eaton Vance, and Pimco over the past three years. But the window for cashing in big on this deal is closing.

Unlike regular mutual funds, closed-end funds have a fixed pool of assets and a set number of shares, which are traded on securities exchanges like stocks. The muni versions invest in bonds issued by U.S. state and local governments and are exempt from federal tax. That may sound dull, but most muni funds spice things up considerably by using leverage to jack up their returns. Here's how it works: A fund borrows money at short-term rates and uses the proceeds to invest in longer-term bonds, which typically pay out higher rates of interest. The fund then captures the spread between the two. One highly rated offering is the Nuveen Municipal Advantage (NMA), which has a 17% one-year return and a yield of 6.3%.

This leveraging strategy can work very well--as long as interest rates are flat or falling, which has been the case since 2001. The danger is that if rates rise, the fund's borrowing costs can soar, hammering overall returns--which might happen later this year if the Fed hikes rates. The upshot? "You'll need to be nimble," says Don Cassidy, a senior research analyst at Lipper. "The first time the Fed raises rates will probably be your signal that the tide's beginning to run out." --Janice Revell