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Investors discouraged by a bond market where yields are ravaged by inflation can find relief in what, for many, is an unfamiliar fixed-income vehicle: closed-end municipal bond funds.
These funds, less common than open funds, are offered by large financial services companies. Some are issued as state-specific offerings and some are national. They allow convenient and additional exposure to tax-exempt municipal bonds, and many currently offer higher yields than higher-quality corporate bond funds, especially on an after-tax basis.
The annual returns of these funds, paid in the form of dividends, now range from less than 3% per annum to over 4% or 5% in some cases – well above the typical returns of many corporate bond funds. higher quality, now ranging from about 2% to 3%.
Because municipal bonds are exempt from federal and many state taxes, the effective after-tax returns of some closed-end municipal bond funds are as high as 7%, several times higher than the after-tax returns of top quality business.
Sales ‘create opportunities’ for new CEF investors
The dynamics of closed-end funds, or CEFs, are markedly different from those of open-ended funds. Because of these differences and current market conditions, muni CEFs now present opportunities for growth in revenue and share price potential.
A recent selloff has weighed on the stock prices of municipal bond funds, creating a historically large price discount to net asset value – the difference between a fund’s assets and liabilities, divided by the number of actions.
Such sales have no real impact on the net asset value, or net asset value, because this is determined in large part by the average value of the bonds held by a fund. But they tend to create opportunities for new CEF investors.
According to Morningstar, muni CEFs were trading at a premium to net asset value in the summer of 2021. Now, a year later, the opposite scenario exists. The rampant selling so far in 2022 has resulted in the most severe decline ever for this investment, with shares now trading at a -6% to -7% discount to net asset value.
Negative performance in muni CEFs has been rare over the past 25 years, according to BlackRock. There have only been five calendar years of negative market price performance, their analysis notes. Large rallies followed most of the selling as investors took advantage of higher yields and depressed asset prices.
The historically substantial CEF discount comes at a time when credit ratings are generally improving in the muni market. According to a report by The Pew Charitable Trusts, after recovering from the impact of pandemic-related costs, state and local government balance sheets are bloated thanks to ample federal relief funds. Rising tax revenues — up about 25% in the first half of this year from 2021, helped by the economic recovery — have further swelled coffers, Pew found.
Buying municipal bond funds offers an inexpensive way to diversify
Purchased directly, municipal bonds often require a minimum investment of $25,000 to $50,000 each, making it difficult to diversify holdings. Owning shares of funds solves this problem and investors can further diversify by using multiple funds.
Open-end funds directly sell stocks on an ongoing basis. But CEFs sell all their shares in advance – once, and that’s it. Investors who wish to enter after a CEF has initially sold all of its shares must buy in the secondary market, through brokers. The captive and static capital of CEFs is not affected by inflows and outflows, which can disrupt open-ended funds.
Much of the sale of muni CEFs this year was driven by the untimely opportunism of impatient investors seeking to position themselves for higher yields. Another selling factor was fear over the ubiquitous headlines about the bearish stock market, inflation and expectations of a near-term recession.
Going forward, the current discount will reduce as share prices are likely to come back into line with net asset values. Historically, they always did, eventually.
Here are three key points for investors to keep in mind:
- It’s usually better to own municipal funds than bonds themselves, even if your portfolio is large enough to warrant it. Typically, the best bond offers are bought by institutional buyers, including fund managers, as soon as they hit the market. The balances available to individuals are less desirable, with lower yields, higher prices relative to credit quality, and less liquidity, making them harder to buy and sell. Funds normally give investors exposure to better bonds.
- Buying closed-end municipal bond funds is not a panacea for risk management, so go ahead with your eyes wide open. It’s a good idea to research the credit ratings of the bond issues held by these funds, the amount of leverage used and, of course, the risk and performance ratings. Many investors focus on yield but overlook credit quality and end up holding funds that underperform over the long term.
- Take note of expenses and fund leverage. As with any investment fund, one of the reasons some CEFs pay higher returns than others may be that their expense ratios are lower or their leverage is higher.
Yields on almost all bonds are rising but remain historically quite low, and net returns after inflation remain well below zero. For investors looking for a higher yielding alternative, CEF municipal bonds can be a good place to store cash for a while to collect returns while positioning themselves for potential gain when the window opens. refresh closes.
— By David Sheaff Gilreath, Certified Financial Planner, Partner and CIO of Sheaff Brock Investment Advisors and institutional asset manager Innovative Portfolios.