Another place to get good returns are with municipal bonds. These instruments have the obvious advantage that the interest that they pay is free of federal taxation and, if you buy bonds from your own state or from Puerto Rico, free of state and local taxes as well. The problem with these bonds, however, is that the interest rates that they pay have fallen quite far in the last two years. In my own state of Connecticut, the returns even for a thirty year bond are quite low. As a result, I would only invest in municipal bonds by means of a closed end fund or a CEF as they are known.
CEFs are companies that issue stock and then use the funds raised to buy other assets, in this case municipal bonds. Most of the CEFs also borrow against the value of the bonds which they purchase and use the loan proceeds to buy more bonds. In the current interest rate environment, this helps to raise the return paid by the CEF. Think about it. The CEF borrows short term at a rate that is extremely low thanks to the efforts of the Federal Reserve. Then, the CEF uses these extra funds to buy municipal bonds that pay substantially more than the CEF itself is paying on the borrowed funds. The spread between the two interest rates is pure profit which gets returned to the shareholders.
There are a great many municipal bond CEFs available for purchase. The question is how best to choose one. I would look at five characteristics of the CEF prior to purchase. First, the most obvious parameter is to look at the current yield of the fund. Right now, the good CEFs are paying just under 6%.
Second, one needs to look at the discount under or premium over net asset value at which the CEF is selling. Let me explain: the bonds and cash held by a CEF less the debt that it has gives one the net asset value of the CEF. Normally, the stock issued by the CEF sells at something near the net asset value of the CEF, but the range could be from ten percent below that figure to ten percent above that figure. When buying a CEF, it is best to look for a fund that is selling at a discount to the net asset value. In that way, the underlying value of the fund helps to support the price. Buying a CEF selling at a premium to the net asset value means that one is paying for something other than the true value of the holdings of the fund, a paper asset that could disappear quickly. Of course, paying a small premium like 1 or 2 percent is not the end of the world, but it is, nevertheless, an additional risk.
The third parameter that must be examined is the level of earnings of the fund compared to the amount that is being paid out in dividends. Obviously, you want a fund that earns more than it is paying out. This means that the dividend at the current rate is likely to stay the same or even be increased. These days, it is also acceptable to buy a fund that earns nearly as much as it pays out provided that it has a substantiall UNII. The UNII held by the fund is the fourth parameter to examine. Without getting too technical, the UNII consists of the past earnings of the fund that it is still holding. In other words, it is money that the fund earned but has not yet distributed. A high UNII means that the fund will have a cash account that it can use for future distributions if its current earnings decline below the current distribution. It is insurance against a cut in the dividend payout.
The last parameter that needs to be checked is that portfolio content of the fund. There is no need to look at each individual bond; it is sufficient to look at the ratings of the portfolio and the timing of maturities and calls. Obviously, a fund with lower ratings for the bonds it holds should yield more than a fund with only high rated debt. I would stay away from any fund that does not have the vast bulk of its assets in at least BBB rated bonds. The call profile is also important. The rate of return paid on new municipal debt is much lower than the average rate was five years ago. If ten percent of a fund's assets get called in the next year, there could be a quick reduction in the earnings of the fund as higher paying bonds are replaced with new one that pay less. This could lead to a reduction in the dividend and a lowering of the yield.
There are risks in municipal bond CEFs of which one must be aware. First, municipalities can and do go bankrupt. Buy buying a CEF, you are diversifying your risk by owning little bits of a great many issues. Still, the muni market could tank if bankruptcies start to mount up. Second, there has been sporadic talk of the taxation of muni debt. Were there to be a serious move towards taxing municipal bond interest, this market would tank. Third, some of the muni CEFs are not all that liquid. One can always get out if one wants to sell, but some of the CEFs will move if a substantial block is sold. For this reason, try to stick with CEFs with a larger market cap. Lastly, there is the obvious interest rate risk. If short term rates start to rise, it is a good time to get out of municipal CEFs since the debt of the funds will begin to cost them more. Similarly, if long term rates start to rise, it is also a good time to sell since rising rates mean falling bond prices which, in turn, means lower prices for the CEFs.
There is a great deal of information available on the CEFs. If you wish to study them in order to find a good one, I recommend that you visit a site called CEF Connect.
Two last notes: First, do not rule out buying a muni CEF from a state other than your own. It is true that will have to pay state income tax on the dividends, but the extra yield for the right fund may more than make up for that tax. Second, muni CEFs are not investments that need to be monitored every day, but they also are not things to buy and then ignore. Interest rate markets move every day, and sometimes the movements are large. You need to pay attention to the CEFs on a frequent basis and not be afraid to sell if the market seems either to be peaking or to be moving against you.
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