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Investors discouraged by a bond market where yields are savaged by inflation may find relief in what, for many, is an unfamiliar fixed-income vehicle: closed-end municipal bond funds.
These funds, less common than the open-ended variety, are offered by large financial services companies. Some are issued as state-specific offerings, and some national. They enable convenient, incremental exposure to tax-exempt municipal bonds, and many currently pay higher yields than investment-grade corporate bond funds, especially on an after-tax basis.
Annual yields from these funds (paid as dividends) now range from less than 3% annually to more than 4% or 5% in some cases — well above yields typical for many investment-grade corporate bonds funds, now ranging from about 2% to 3%.
As muni bonds are exempt from federal tax and state tax in many states, effective after-tax yields of some muni CEFs are as high as 7%, several times higher than after-tax yields from investment-grade corporate funds.
The dynamics of closed-end funds are markedly different from those of open-ended funds. Because of these differences and current market conditions, muni CEFs now present opportunities for both income and potential share-price growth.
A recent sell-off has tamped down share prices on municipal bond funds, creating an historically wide price discount from net asset value — the difference a fund’s assets and liabilities, divided by the number of shares.
Such sell-offs have no real impact on NAV, as this is determined largely by the average value of the bonds a fund holds. But they tend to create opportunities for new CEF investors.
According to Morningstar, muni CEFs were trading at a premium to NAV in the summer of 2021. Now, a year later, the opposite scenario exists. Rampant selling thus far in 2022 has resulted in the most severe drawdown ever for this investment, with shares now trading at a discount of -6% to -7% from NAV.
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 sell-offs, as investors took advantage of higher yields and depressed asset prices.
The historically substantial CEF discount comes at a time of generally improved credit ratings in the muni market. After recovering from the impact of pandemic-related costs, the balance sheets of state and local governments are flush thanks to abundant federal relief funding, according to a report from The Pew Charitable Trusts. Increased tax revenues — up about 25% in the first half of this year over 2021, thanks to the economic recovery — have further swelled coffers, Pew found.
Purchased directly, muni bonds often require a minimum investment of $25,000-$50,000 apiece, making it difficult to diversify holdings. Owning shares of funds solves this problem, and investors can diversify further by using multiple funds.
Opened-ended funds sell shares directly on an ongoing basis. But CEFs sell all their shares up front — once, and they’re done. Investors who want to get in after a CEF initially sells all its shares must buy on the secondary market, through brokers. CEFs’ captive, static capital is unaffected by inflows and outflows, which can roil open-ended funds.
Much of this year’s selling of muni CEFs has been motivated by ill-timed opportunism among impatient investors seeking to position for rising yields. Another factor driving selling has been fear stirred by ubiquitous headlines about the bear stock market, inflation and expectations of near-term recession.
Eventually, the current discount will narrow because share prices are likely to come back into alignment with net asset values. Historically, they always have, eventually.
Here are three key points for investors to keep in mind:
- It’s generally better to own muni funds rather than bonds themselves, even if your portfolio is large enough to justify this. Typically, the best bond offerings are snapped up by institutional buyers (including fund managers) as soon as they hit the market. The remainders available to individuals are less desirable, with lower yields, higher prices relative to credit quality and less liquidity, making them more difficult to buy and sell. Funds normally give investors exposure to better bonds.
- Buying closed-end municipal bond funds isn’t a panacea for risk management, so go in with your eyes wide open. It’s a good idea to research the credit ratings of the bond issues these funds hold, the amount of leverage used and, of course, risk and performance ratings. Many investors focus on at yield but overlook credit quality and end up owning funds that underperform in the long run.
- Take note of funds’ expenses and leverage. As with any investment fund, one reason some CEFs pay higher yields than others may be that their expense ratios are lower or their leverage is higher.
Yields of nearly all bonds are rising but still quite low historically, and net yields after inflation remain well below zero. For investors looking for a higher-yielding alternative, muni bond CEFs may be a good place to park some money for a while to collect yield while positioning for potential gain when the discount window closes.
— By David Sheaff Gilreath, certified financial planner, and partner and CIO of Sheaff Brock Investment Advisors and institutional asset manager Innovative Portfolios.