With so much uncertainty in the stock market, and with the possibility of tax increases on the horizon, investors have been allocating funds into tax free bonds (municipal bonds), directly and through tax free income closed end funds. Tax free closed end funds or CEFs have several advantages over investing in municipal bonds directly.
Many of these CEFs have yields of 5% or more, such as the Blackrock Apex Municipal Fund Inc. (APX), which sells at a discount to net asset value, uses almost no leverage, and yields 5.7%. The Nuveen New York Dividend Advantage Municipal Fund 2 (NXK) has a yield of 5.8%, is currently trading at a discount to NAV, and has about 26.5% leverage, much lower than the average leverage of 34.7% for all the CEFs. The Nuveen Investment Quality Municipal Fund Inc. (NQM) yields 6.6%, utilizes about 29% leverage, and trades at a slight discount. WallStreetNewsNetwork.com just updated its list of tax free income closed end funds, which describes almost 200 ETFs,, including yields, discounts/premiums, leverage, management fees, date founded, and other information.
High income taxpayers love municipal bonds, as they provide income that is tax free from Federal income taxes, and if the bond is issued from the state in which the taxpayer resides or from one of the territories of the US such as Puerto Rico, then the income is also exempt from state taxes. Munis are generally issued by states, counties, cities, and other governmental entities such as school districts, sewer districts, bridges, and water and power departments. Here are the advantages and disadvantages of munis and muni CEFs.
1. You can pick and choose what governmental agency you want to loan money to. Maybe you want to stick with the bonds from the cities and counties near you that you are familiar with.
2. Bonds have a maturity date. This means that no matter how high interest rates go, and no matter how low the bonds drop in value, at maturity, the bonds are paid off at par.
3. What your bond is worth is what your bond is worth; in other words, the trading price of CEFs may be far higher or lower than the net asset value of the fund.
1. Higher minimum investment. Although munis are issued in $5,000 denominations, a round lot is generally considered by many firms to be $100,000.
2. Less diversification. Because of the higher minimum, investors can't own as many diverse bonds as they could with a CEF.
3. Interest payments only twice a year.
4. No professional management or monitoring.
5. Illiquidity. Munis are not traded on an exchange, and estimated prices given on brokerage statements can be way off from what brokers will actually offer you if you want to sell. This actually happened to me; I received an offer of five points less than what the statement showed a couple days before, with no change in interest rates over those couple days.
Municipal Bond Closed End Funds
1. No minimum investment. You could technically buy one share.
2. Monthly income.
3. With the monthly income, you receive you capital back faster, and you can do quicker compounding of your income.
4. Very liquid; traded on major exchanges.
5. Narrow bid and asked spreads compared to municipal bonds.
6. Can sell off small portions if funds are needed. In other words, if you had $10,000 invested and needed to cash in $1,000 worth, you could do it with a CEF but not with municipal bonds.
1. You pay a management fee and other administrative fees.
2. Some CEFs use leverage. You should beware that this increases the risks to the investor.
3. Some CEFs may be trading at a premium to net asset value. You want to look for those trading at a discount.
4. No maturity date (other than a few target funds). If rates go up and continue to rise during your lifetime, you may never get your principal back.
As you can see, there are benefits to both municipal bonds and municipal bond closed end funds. Just make sure that you are familiar with the risks and costs of each.
Disclosure: Author does not own any of the above at the time the article was written.