It's tax season again. Have you noticed a lot of dividends and interest showing up on your tax return? Wouldn't it be nice if you could convert that taxable income into non-taxable income? The one primary way of getting tax free interest is through municipal bonds.
One option is to owns the bonds directly and the other is by purchasing municipal bond closed end funds, sometimes referred to as tax-free CEFs or tax-free stocks. These closed end funds own muni bonds that pay interest that is exempt from Federal income taxes and may be exempt from state income 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. Municipal bonds are usually issued by states, counties, cities, and other governmental entities such as school districts, sewer districts, bridges, and water and power departments. WallStreetNewsNetwork.com has list of over 100 tax-free income CEFs, and more than 80 paying out yields more than than 5%.
There are many advantages besides the non-taxable income of these CEFs. Almost all of them pay dividends on a monthly basis, whereas, if you by an individual bond, the interest is paid semi-annually. CEFs have no minimum investment, whereas municipal bonds are sold in $5,000 denominations and many brokers have minimum purchase requirements of $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, unlike individual bonds. In addition, CEFs provide diversification by owning many bonds in the portfolio.
One tax free CEF with a long term track record is the Dreyfus Strategic Municipal Bond Fund (DSM), which was founded in 1989. It currently yields 6.1%, and is selling for a 8.2% discount to Net Asset Value. The Net Asset Value, also known as the NAV, is the intrinsic value of the shares if the entire fund were liquidated and all the funds distributed among the shareholders. The fund does utilize some leveraging, currently 34%, which is somewhat lower than many other tax free CEFs. The advisor fee is 0.50%.
If you live in New York, you can consider the PIMCO New York Municipal Income Fund (PNF), founded in 2001. The fund yields 5.9%, and trades at a 3.9% discount to NAV. Leverage is 37.7%, and the advisor fee is 0.65%.
California residents may consider the Invesco Van Kampen California Value Municipal Income Fund (VCV), with a payout rate of 6%. It has a discount to NAV of 4%, with leverage of 35%. The company, founded in 1992, charges an advisor fee of 0.88%.
Here are some issues to watch out for before investing in tax free CEFs:
* a highly leveraged portfolio
* high management/advisor fees
* trading at a premium to net asset value
* bonds which are subject to the Alternative Minimum Tax
* low quality bonds in the portfolio
But there is one major risk, which is a rise in interest rates, which will cause the bonds to drop in price and therefore causing the CEFs to fall also. It is interesting to note that I have been mentioning that risk for several years, yet rates continue to remain low. Interest rates will go up eventually, it's just a matter of when.
A list of tax free income closed end funds, which includes yields, discounts and premiums, leverage, management fees, date founded, and other information, is available at WallStreetNewsNetwork.com.
Disclosure: Author did not own any of the above at the time the article was written.