These funds can juice your tax-free portfolio income. Just be sure to mind the risk
The recent run-up in rates has dented municipal bond prices, leaving one corner of the market offering especially attractive tax-free income. Municipal bonds posted a negative return of 6.35% in the third quarter, the worst quarter since 1981, according to Nuveen. This was largely driven by a sharp spike in rates rather than credit deterioration, the firm found. Bond yields and prices move in opposite directions, so even as prices took a hit, income generation was on sale. At around the start of October, the yield on the Bloomberg Municipal Bond Index reached 4.78%. “What that’s provided, in our view, is a very good opportunity set,” said Dan Close, head of Nuveen Municipals. “It’s almost impossible to call the absolute bottom, but if you can pick up the rates we get right now, you’re certainly being paid to wait.” He added that the “higher for longer” theme for interest rate policy has returned as market expectations point to a greater likelihood of the Federal Reserve raising rates in December. Fed funds futures trading suggests a roughly 71% likelihood of policymakers hiking rates at their final meeting of the year, according to the CME FedWatch tool. The recent decline in muni bonds is especially attractive for high income investors, who benefit from their tax-free treatment at the federal level – and generally tax-exempt status at the state and local level, if an investor lives in the issuing state. Consider an investor who is in the 32% marginal federal income tax bracket and is subject to the 3.8% net investment income tax. Buying a muni bond yielding 3.5% would equal a taxable bond with a yield of 5.45%, according to New York Life Investment Management . There are different ways to tap this market, and for those who are eyeing hefty yields and can stomach volatility, closed-end funds can provide compelling income generation — albeit with an added dose of complexity. Closed-end funds Closed-end funds differ from open-ended mutual funds and exchange-traded funds in several ways. First, they have a limited number of shares and trade throughout the day on a stock exchange, and trade at a premium or discount to their net asset value. Second, closed ends also use leverage, which can enhance returns over time but can also introduce price volatility – including magnifying losses. Finally, fees are almost always higher for closed-end funds versus their ETF cousins. That’s because they’re actively managed and leverage adds to expenses. Expense ratios on closed-end funds can top 1%, and higher costs eat into returns. Investors in closed-end funds that use municipal bonds still get monthly tax-free income, but what’s distributed can come from a combination of interest payments, realized capital gains from the sale of underlying holdings and return of capital. Consider that Nuveen’s Quality Municipal Income Fund (NAD) has a distribution rate of 8.2% and trades at a discount of 3.64%. BlackRock offers the MuniHoldings Fund (MHD) , which has a distribution rate of 6.79% and sells at a discount of 9%. “For clients looking for a pure income play and who can close their eyes to daily volatility on net asset value and market price, these tend to be very efficient vehicles for distributing high levels of tax-exempt income,” said Close at Nuveen. But Investors should be aware of the trade-offs if they’re thinking about getting in. “Most of our clients are retirees whose priority is generating tax-efficient income and managing risk,” said Tyler McConville, CFP and private wealth advisor at The Capital Group in Madison, Wisconsin. “Closed-end funds can give you yield, but they include discount to NAV risk and leverage, and that may not align with every retiree’s objective.” Individual issues and ETFs Investors seeking simplicity – and who have the cash to manage the purchase – may consider building a portfolio of laddered municipal bonds as a way to manage the risk of rising interest rates. A ladder involves purchasing bonds with varying maturities and then reinvesting the proceeds into new issues as holdings mature. “I can match cash needs and hold to maturity, and many investors find that reassuring,” said Eileen Olson, CFP and founder of Emerald Wealth in Daufuskie Island, South Carolina. The catch is that a significant pool of money is needed to build a diversified portfolio of munis. Olson estimates clients need at least $250,000. For those with more modest savings, an ETF can provide diversification even if investors don’t have that kind of money. But investors have to be mindful that they’ll see price fluctuations as rates move, and should be aware of interest rate risk – or duration – as they decide on a fund. Vanguard has an actively-managed Core Tax-Exempt Bond ETF (VCRM) , with an average duration of 7.5 years and a 30-day SEC yield of 4.49%. But the largest muni bond funds by assets include the passively managed Vanguard Tax-Exempt Bond ETF (VTEB) and iShares National Muni Bond ETF (MUB) . “The bigger theme here is this is an interesting time for the muni market,” said Matthew Wrzesniewsky, Vanguard’s head of fixed income client portfolio management. His team likes the intermediate part of the muni yield curve. “Those windows of opportunity have opened up, and we’re still there,” Wrzesniewsky said.
