Wealth

Op-ed: This ‘unfamiliar’ type of bond fund may offer opportunities for fixed-income investors

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Investors who feel discouraged by a market where yields are savaged and inflation is likely to find relief in an unfamiliar fixed income vehicle: closed-end municipal bonds funds.

These funds are not as common as the open-ended varieties, but they are offered by large financial institutions. Some funds are issued as national offerings and some state-specific. They allow for convenient, incremental exposure tax-exempt municipal bonds. Many currently pay higher yields that investment-grade corporate bond funds, especially after-tax.

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%.

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Muni bonds are exempted from federal tax and many state taxes. The effective after-tax yields for some closed-end municipal bond funds can be as high as 7.7%. This is several times higher that after-tax yields for investment-grade corporate funds.

CEF investors are able to ‘create opportunities’ through the sale of assets

CEFs are very different from open-ended funds in terms of their dynamics. These differences and current market conditions make muni CEFs attractive for potential income growth and share-price growth.

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

These sell-offs do not have any effect on net asset value (or NAV), as this is largely determined by the average bond value of each fund. They can, however, create opportunities for CEF investors.

Morningstar reports that muni CEFs traded at a premium to NAV during summer 2021. The opposite situation is now, one year later. The 2022 market has seen a lot of rampant selling, which has led to the largest drawdown for this investment. Shares are now trading at a discount between -6% and -7% below NAV.

According to the, negative performance in muni-related CEFs has been rare for the past 25 years. BlackRock. Their analysis notes that there have only been five years of negative performance in market prices. Large rallies were seen after most sell-offs as investors took advantage depressed asset prices and higher yields.

CEF discounts are historically significant at a time when credit ratings in the muni sector have improved. According to a report from, the federal relief funding has helped to flush the balance sheets of local and state governments after they have recovered from the pandemic-related effects. 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.

A cheap way to diversify is to buy muni bond bonds

Muni bonds are purchased directly and require a minimum of $25,000 to $50,000 per unit. This makes it difficult for investors to diversify their holdings. This problem is solved by owning shares in funds. Investors can also diversify further using multiple funds.

Shares are sold by open-ended funds directly on an ongoing basis. But CEFs sell all their shares up front — once, and they’re done. Investors who wish to buy shares from a CEF must purchase on the secondary market through brokers. CEFs’ static capital is immune to inflows and withdrawals that can roil open ended funds.

A lot of the year’s selling of Muni CEFs was caused by this year’s economic downturn. Impatient investors who are looking for rising yields were motivated to sell. Fear stoked by headlines about the bear stockmarket, inflation and near-term recession has also been a factor in selling.

The current discount will eventually narrow as share prices will likely return to net asset values. They have always been there, historically.

These are three important points that investors should keep in mind:

  1. It is generally better to own muni bonds than muni funds, even if you have enough assets to justify it. The best bond offerings are usually snapped up by institutional buyers (including fund managers) as soon as they hit stock. Individuals are less likely to be able to purchase or sell the remainders. They have lower yields and higher prices relative to credit quality. Funds typically give investors exposure for better bonds.
  2. Closed-end municipal bonds funds aren’t the best way to manage risk. Keep your eyes open. It is a good idea research the credit ratings of the bonds these funds hold, the leverage used, and, of course risk and performance ratings. Many investors place too much emphasis on yield and overlook credit quality, and end up with funds that are not long-term performers.
  3. Pay attention to funds’ expenses and leverage. CEFs can pay higher yields than other investment funds due to their expense ratios or higher leverage.

While yields on almost all bonds are increasing, they are still very low historically and net yields after inflation are well below zero. Investors looking for a higher yielding option may consider muni bond CEFs. This allows them to store some money and earn a profit 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.

Source: CNBC

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