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Closed-end municipal bond funds may profit fixed-income investors

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Investors discouraged by a bond market where yields are savaged by inflation may find relief in what, for a lot of, 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 corporations. Some are issued as state-specific offerings, and a few national. They permit convenient, incremental exposure to tax-exempt municipal bonds, and lots of 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 lower than 3% annually to greater than 4% or 5% in some cases — well above yields typical for a lot of investment-grade corporate bonds funds, now starting from about 2% to three%.

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As muni bonds are exempt from federal tax and lots of states’ taxes, effective after-tax yields of some closed-end municipal bond funds are as high as 7%, several times higher than after-tax yields from investment-grade corporate funds.

Sell-offs ‘create opportunities’ for brand new CEF investors

The dynamics of closed-end funds, or CEFs, are markedly different from those of open-ended funds. Due to these differences and current market conditions, muni CEFs now present opportunities for each income and potential share-price growth.

A recent sell-off has tamped down share prices on municipal bond funds, making a historically wide price discount from net asset value — the difference between a fund’s assets and liabilities, divided by the variety of shares.

Such sell-offs haven’t any real impact on net asset value, or NAV, as this is decided largely by the common value of the bonds a fund holds. But they have an inclination to create opportunities for brand new CEF investors.

Based on Morningstar, muni CEFs were trading at a premium to NAV in summer 2021. Now, a 12 months later, the other scenario exists. Rampant selling so far in 2022 has resulted in probably the most severe drawdown ever for this investment, with shares now trading at a reduction of -6% to -7% from NAV.

Negative performance in muni CEFs has been rare over the past 25 years, in line with BlackRock. There have only been five calendar years of negative market price performance, their evaluation notes. Large rallies followed most sell-offs, as investors took advantage of upper yields and depressed asset prices.

The historically substantial CEF discount comes at a time of generally improved credit rankings within the muni market. After recovering from the impact of pandemic-related costs, the balance sheets of state and native governments are flush because of abundant federal relief funding, in line with a report from The Pew Charitable Trusts. Increased tax revenues — up about 25% in the primary half of this 12 months over 2021, because of the economic recovery — have further swelled coffers, Pew found.

Buying muni bond funds offers an inexpensive technique to diversify

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 utilizing multiple funds.

Opened-ended funds sell shares directly on an ongoing basis. But CEFs sell all their shares up front — once, and so they’re done. Investors who need 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 may roil open-ended funds.

Much of this 12 months’s selling of muni CEFs has been motivated by ill-timed opportunism amongst impatient investors searching for to position for rising yields. One other factor driving selling has been fear stirred by ubiquitous headlines concerning the bear stock market, inflation and expectations of near-term recession.

Eventually, the present discount will narrow because share prices are more likely to come back into alignment with net asset values. Historically, they at all times have, eventually.

Listed below are three key points for investors to bear in mind:

  1. It’s generally higher to own muni funds somewhat than bonds themselves, even in case your portfolio is large enough to justify this. Typically, the very 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 fewer liquidity, making them tougher to purchase and sell. Funds normally give investors exposure to raised bonds.
  2. Buying closed-end municipal bond funds is not a panacea for risk management, so go in together with your eyes wide open. It’s an excellent idea to research the credit rankings of the bond issues these funds hold, the quantity of leverage used and, in fact, risk and performance rankings. Many investors deal with yield but overlook credit quality and find yourself owning funds that underperform in the long term.
  3. Pay attention to funds’ expenses and leverage. As with all investment fund, one reason some CEFs pay higher yields than others could also be that their expense ratios are lower or their leverage is higher.

Yields of nearly all bonds are rising but are still quite low historically, and net yields after inflation remain well below zero. For investors on the lookout for a higher-yielding alternative, muni bond CEFs could also be an excellent place to park some money for some time to gather 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 Modern Portfolios.

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