What better way to start the new year than with tax free income. Now is a great time to look at your portfolio and consider moving some of the funds you have in a regular bank account (making less than 1% interest, fully taxable) to either municipal bonds or 'tax free stocks'.
Tax free stocks are technically closed end funds or CEFs that own municipal bonds which pay tax free interest. There are risks of course like any investment, such as the potential increase in interest rates, which would cause the price of the shares to drop. In addition, many CEFs use leverage to obtain higher yields.
But there are many advantages besides the tax free income feature. Almost all of these CEFs pay dividends monthly, whereas, if you by an individual bond, the interest is paid semi-annually. CEFs have no minimum investment, whereas bonds are sold in $5,000 denominations and many brokers have minimum purchases ranging from $15,000 to $25,000. You also have better liquidity with CEFs as prices are quoted real time and quotes are immediately available on the Internet. CEFs provide diversification through a group of bonds in the portfolio.
Municipal bonds pay interest that is exempt from Federal taxes and may be exempt from state taxes if issued in the state you live in or issued by one of the US territories, such as Puerto Rico, the Virgin Islands, or Guam. Munis are generally issued by states, counties, cities, and other governmental entities such as school districts, sewer districts, bridges, and water and power departments.WallStreetNewsNetwork.com just recently updated over 150 of these tax-free income CEFs, and more than 100 providing yields in excess of 5%.
One example, appropriate for New York residents, is Nuveen New York Investment Quality Municipal Fund Inc. (NQN) which seeks to provide current income exempt from regular Federal and New York State and City income tax, and pays a fairly high yield of 6.2%. However, it does use leverage, to the tune of 38%, to achieve its high yield. The fund trades at about a 3% discount to net asset value, also referred to NAV, at the time of writing. The management fee of 0.68% is below the overall average of all tax free CEFs. It has been paying dividends since 1990. Slightly less than 10% of the bonds in the portfolio are subject to the alternative minimum tax, also referred to as AMT.
California residents might want to take a look at the Nuveen California Municipal Value Fund Inc. (NCA), which doesn't use any leverage to achieve its 5.0% yield, free of Federal and state income taxes. It currently trades at an 8.3% discount to NAV, and carries a reasonable 0.57% management fee. The CEF, which has been around since 1987, has about 8.5% of its portfolio in AMT bonds.
For a CEF that is diversified nationwide, there is the Federated Premier Intermediate Municipal Income Fund (FPT), which seeks to provide current income exempt from federal income tax, including AMT. The fund yields 5.6% and has no AMT bonds in the portfolio. It is trading at a 1.9% discount to net asset value. Leverage is quite high at 40% but the management fee is a reasonable 0.46%. Income has been paid since 2002.
Another option is the Western Asset Municipal Partners Fund Inc. (MNP), yielding 5.2%, and trading at a 5.6% discount to NAV. Leverage is at 37%, and the CEF carries a management fee of 0.82%, slightly above the average. The CEF has been around since 1992.
The issues to watch out for with tax free CEFs:
* high leverage
* high management fees
* trading at a premium to NAV
* bonds in the portfolio that may be subject to the Alternative Minimum Tax
* quality of bonds in the portfolio
For a list of tax free income closed end funds, which includes yields, discounts and premiums, leverage, management fees, date founded, and other information, go to WallStreetNewsNetwork.com.
Disclosure: Author did not own any of the above at the time the article was written.