Municipal closed-end funds (“CEFs”) currently offer high levels of tax advantaged income and can often be purchased at a discount to their current net asset value.
Amid concerns around the coronavirus and oil prices, market volatility has driven investors into higher quality assets, pushing down bond yields. For example, the 10-year US Treasury yield has moved down 134 (1.34%) basis points year to date, hitting as low as 0.54%1. In our opinion, major central banks seem set on maintaining easy monetary policies, meaning interest rates and bond yields look more likely to linger near historic lows.
In this environment, finding income remains at the top of investors’ minds. Municipal bonds have long offered multiple benefits to investors, including tax advantages and attractive income potential both on a relative and tax equivalent basis. Municipal closed-end funds (“CEFs”) can further enhance income potential through active management and taking advantage of the vehicle’s “closed” structure.
Strong demand for munis
Municipal bonds are known for their high credit quality, low default rates and tax advantages. Munis have performed well this year (up 3.1%2 through February 28) as investors moved into higher-quality assets given global growth concerns, and more recently, worries surrounding the coronavirus pandemic. In fact, municipal bond mutual funds have seen 60 straight weeks of net inflows3.
When evaluating municipal bonds, it is important to consider their tax equivalent yield. Municipal bonds are exempt from federal taxes and investors can potentially receive additional tax benefits by purchasing state and local tax-exempt bonds issued by states and municipalities in which they reside. This can be particularly beneficial for residents of states with higher income tax rates, such as New York, New Jersey, and California.
A potential boost from CEFs
Investors looking to be more aggressive in their search for income may benefit from adding municipal CEFs to their portfolio. Unlike open-ended mutual funds, the “closed” structure provides greater flexibility in the types of investment strategies portfolio managers can use. Because CEFs trade directly on the stock exchange, one investor to another, managers don’t have to worry about deploying new cash inflows and or forced selling from cash outflows; this allows them to stay invested for the long term. If the bonds being purchased are yielding less than the current portfolio, this could negatively impact the fund’s distribution rate. The CEF structure also allows for the use of leverage, which can enhance income and return potential.
Given these structural benefits, municipal CEF’s are currently offering a median tax equivalent yield of 8.5%, which is higher than the current yield of individual municipal bonds or municipal mutual funds, as the chart below shows. They have also outperformed their open-end peers in 20 of the last 25 calendar years, on a net asset value (“NAV”) basis, including average annual outperformance of 2.4% over that period.