With the stock market volatility and uncertainty, and the possibility of future tax increases, many investors are turning to tax free bonds, also known as municipal bonds and munis, or they are choosing the alternative tax free income closed end funds, of which there are over 250 available according to WallStreetNewsNetwork.com. When deciding which is the better way to go, investors should know the advantages and disadvantages of muni bonds versus closed end funds, generally referred to as CEFs.
Municipal bonds have always been popular with high income taxpayers, since the bonds provide income that is tax free from Federal income taxes. If the bond is issued from the state where the taxpayer lives or from one of the territories of the US such as Puerto Rico, Guam, or the Virgin Islands, 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, and water and power departments.
One of the advantages of munis is that you can pick and choose what governmental agency you want to loan money to. Investors may be better off sticking with those that fund projects with guaranteed income streams such as bridge tolls.
In addition, bonds have a maturity date. Why is that important? It 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.
There are some drawbacks though. Bonds carry a high minimum investment. Although munis are issued in $5,000 denominations, a round lot is generally considered by many brokerage firms to be $100,000.
There is less diversification available to investors. Because of the higher minimum, investors can't own as many diverse bonds as they could with a CEF.
Also, interest payments are made only twice a year, and there is no professional management or monitoring of the bonds.
One last disadvantage is illiquidity. Munis are not traded on an exchange, and estimated prices given on brokerage statements may be way off from what brokers will actually offer you if you want to sell.
So what about tax free closed end funds? First, there is no minimum investment. If your brokerage firm would allow it, you could conceivably buy one share of a CEF.
The CEFs provide a monthly income, and with that monthly income, the investor's capital is returned faster, which means you can do faster compounding of your income. Also, since CEFs are traded on major exchanges, they are very liquid.
Taking a look at the negatives of muni CEFs, you do pay a management fee and other administrative fees, plus some CEFs use leverage, which increases the risks to the investor. Some CEFs may be trading at a premium to net asset value, which should be avoided.
With the exception of a few target funds, there is no maturity date, so if rates go up and continue to rise during your lifetime, you may never get your principal back.
As you can see, there are advantages and disadvantages to both municipal bonds and CEFs. You have to be the one to decide which way to go. If you want a list of municipal bond closed end funds, which can be downloaded, sorted, and updated, go to WallStreetNewsNetwork.com.