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10 bond funds yielding 10%
Municipal bonds are carrying hefty yields. Closed-end funds can leverage those returns to make even more. And it's all tax-free -- just don't hold the funds for the long term.
By Timothy Middleton
Theres a better way to make money in this market than the market.
Municipal bonds are in a deep funk, and the result is yields equal to or even higher than those on Treasury bonds. For most taxpayers, that means substantially higher after-tax returns, because Treasury interest is taxable on your federal return but municipal interest isn't.
And the highest returns of all are coming from closed-end muni funds, which use leverage to boost their yields. Many are yielding well north of 7%, which for many of us is equal to more than 10% on a tax-adjusted basis.
We like municipal bonds, most of which I own personally through closed-end funds, says William Gross, manager of Pimco Total Return Fund (PTTRX) and the nations foremost fixed-income investor.
In bear markets, and thats what were talking about here, municipals almost always perform very defensively, Gross says. Their prices go down more slowly than do Treasurys and corporate bonds.
Packing more punch
Municipals should be the core bond holding of upper-income investors, but now theyre attractive even to those in the lowest income brackets. Closed-ends pack more punch into them by using leverage to boost yields. That can spell trouble when interest rates rise, meaning these funds arent necessarily a long-term bet. Now, though, theyre an excellent trading opportunity.
| High-yielding closed-ends | | Fund | Yield (%) | Taxable-equivalent yield (%) | Premium/discount to NAV | | Dreyfus Strategic Muni (LEO) | 7.68 | 10.98 | 5.28 | | Dreyfus Muni Income (DMF) | 7.59 | 10.84 | 2.15 | | Putnam Investment-Grade Muni (PGM) | 7.53 | 10.75 | 5.42 | | BlackRock Muni Income (BLE) | 7.53 | 10.75 | -2.34 | | Colonial High Income (CXE) | 7.51 | 10.73 | -0.78 | | MuniHoldings Fund II (MUH) | 7.47 | 10.68 | -0.73 | | MuniHoldings Fund (MHD) | 7.40 | 10.57 | -2.36 | | Pimco Muni Income III (PMX) | 7.35 | 10.50 | -1.09 | | BlackRock Muni Bond (BBK) | 7.29 | 10.42 | -1.90 | | Municipal High Income (MHF) | 7.28 | 10.39 | -3.28 |
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Notes: Selected funds. Yields on share price. Tax equivalency based on top federal tax rate of 35%. Data as of Oct. 15.
Source: ETFconnect.com
Municipal bonds are yielding about 3.8% on the 10-year note, only slightly less than Treasurys of similar maturity. Closed-end funds can substantially boost their yields by selling preferred fund shares, in an amount equal to $1 for every $2 they have in assets. They pay money-market rates on the preferred, currently about 1%, and use the proceeds to buy higher-yielding bonds.
The effect is to generate bond yields to the portfolio, and then in monthly dividends to shareholders, substantially greater than those available from conventional mutual funds, which cant use leverage. In todays market, some closed-end municipals are yielding twice as much as mutual funds.
How prices are set for closed ends, bonds
Closed-ends are actively managed portfolios of a fixed size; i.e., they dont face redemptions or, except in certain circumstances, accept new money. Supply and demand are reflected in the share price, which is why many muni funds have price discounts.
They trade like stocks, which means you have to pay commissions. But it also means you pay the market price, not the net asset value that's assigned each day when the market closes.
Bonds, in turn, trade at prices the market determines, based on their coupons. A 10-year municipal yielding above the current market would see its price rise above par; price is the reciprocal of a bonds yield.
So municipal yields are rich because their prices are depressed: California is all but broke, and the recent recession has pushed other large issuers like New York to the brink of crisis. Also, bonds linked to the Master Settlement Agreement on tobacco have been thrown into a cocked hat by an Illinois judge in an unrelated tobacco lawsuit.
But, notes Lee Cunningham, co-manager of Federated Premier Municipal Income (FMN), a credit crisis for municipalities is not the same as for a corporation. They have the ability to raise taxes. And if taxpayers are reluctant to go along, courts can compel states to service their bonds, even if they have to close schools.
Cunninghams fund is yielding 7.2%, creating a taxable equivalent yield of 10.29%. It trades at a 1.62% discount to net asset value.
4 keys to finding good closed-end muni funds
As I look at closed-end municipal funds, I focus on four key considerations:
- Leverage: In a rising market -- and I believe this is an up market for these funds, because the prices of the bonds they own are depressed, which is why their yields are so high -- leverage works with you. It works the opposite way when rates are rising, so closed-ends are dangerous long-term holdings. So I would buy them now with the intent of selling them if rates were to rise substantially.
- Discount/premium: Im not so much concerned with the absolute level of a funds premium or discount to net asset value, but rather its relationship to the group at the time I buy. Currently, most national muni funds have small discounts. A large premium, therefore, discourages me. Eaton Vance Municipal Income (EVN) has one of the highest yields in the marketplace, 8.05% (which is equivalent to 11.51% on a taxable bond) but its trading at a premium of 9.48% to net asset value.
All things being equal, therefore, I could lose 10% of my investment if the premium disappeared; thats too big a risk for me. By contrast, MuniHoldings Fund (MHD) is yielding 7.4% and trading at a discount to NAV of 2.36%. BlackRock Municipal Income (BLE) yields 7.53% with a discount of 2.34%; either of these carries less sentiment risk than the Eaton Vance portfolio.
- National versus state: Im writing here about national muni funds but I live in New Jersey, where the top local tax rate is 6.37%. Therefore, buying a New Jersey-only fund makes sense to me. One hundred dollars of tax-free bond interest saves a top-rate taxpayer $35 on his federal return, and an additional $4.14 on his New Jersey return. (The state amount is less than the marginal rate because of the deductibility of the interest on the federal return.)
Yields on New Jersey municipal closed-ends currently top out around 6.8%, which was the yield on BlackRock New Jersey Municipal Bond Trust (BLJ) on Oct. 15. In the top federal and local bracket, thats a taxable-equivalent yield of 11.17% -- about a third of a point better than the yield available on a national fund.
- Nuts and bolts: I want an experienced manager backed by a high-quality vendor, and a fund with a good record and low expenses. BlackRock New Jersey Municipal Investment Quality Municipal Trust (RNJ comes from one of the premium fixed-income investment companies, has had the same manager in place for 10 years of superior performance and has an expense ratio of 0.45%.
Nuveen New Jersey Investment Quality Municipal Fund (NQJ has a similar long-term record, a manager with five years of experience and comes from another dominant fixed-income shop. But this funds expense ratio is 0.80%. Nuveen has only been able to match the net performance of the BlackRock fund by producing greater gross returns, and whatever was required to do that doesn't benefit shareholders. Probably what was required was taking more risk. Ill take the lower ratio.
Better for taxable accounts
Researching closed-end funds is a problem, but two Web sites offer basic information: the Closed-End Fund Center and ETFConnect. (See the links at the left under Related Sites.) The former is sponsored by the Closed-End Fund Association, the industrys trade group, and the latter by John Nuveen.
There are 228 closed-end muni funds in the ETFconnect database, so choices are abundant. In my taxable investment account, closed-end muni funds are the only fixed-income investments I am planning to make, though I wont be buying any until three days after this column appears.
Note I said taxable account: Munis are unsuited for an IRA or 401(k), and most plan administrators wont allow you to buy them. Even if they do allow it, dont do it; retirement plan moneys are already tax-favored.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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