Harry Domash's Winning Investing

Market Too Exciting?

Here's How to Slow Things Down

If you think this market is getting too exciting, this might be a good time to slow things down and focus on generating steady income while minimizing risk.

And it would be really nice if that income were federally tax-free!

You can do all three by adding municipal bond funds to your portfolio. Cities, counties, states, and other government agencies sell municipal bonds to raise cash to finance the construction of capital projects such as schools and highways.

About Municipal Bonds

Municipal bonds pay dividends, and even better, those dividends are federal tax-free. While you could buy muni bonds individually through your stockbroker, it’s easier and potentially more profitable to hold bond funds instead. While many mutual funds and exchange-traded funds (ETFs) focus on bonds, a category that you probably haven’t paid much attention to, closed-end funds, is usually your best option.

About Closed-End Funds (CEFs)

Closed-end funds are similar to conventional (open-end) mutual funds, but with one major difference. Rather than selling and redeeming shares as needed, closed-end funds sell a fixed number of shares when launched. After that, the fund trades just like a stock. Buyers purchase from existing shareholders, and shareholders must find a buyer when they sell.

Many closed-end funds use leverage (borrowings) to enhance shareholder returns. Basically, they borrow at, say, 1.5%, and invest the borrowed funds in bonds paying 3% or so. Consequently, many muni closed-end funds pay monthly dividends equating to 4% - 5% dividend yields vs. 2.5% to 3% for conventional mutual funds. Here’s one more thing you need to know about closed-end funds.

Because they create and redeem shares as needed, conventional mutual funds always trade at their net asset value (NAV), which is the per share value of the fund’s assets. But, not closed-end funds. Because their share prices reflect the balance of supply and demand, they typically trade either above (premium) or below (discount) their NAVs.

Tax Math: 5% = 7.7%.

Most muni funds pay monthly dividends equating to 4.5% to 5.5% dividend yields. But, a 5.0% non-taxable yield is equivalent to a 7.7% taxable payout (assuming 35% tax rate).

Pay Attention to CEF Premiums

While many investors seek out funds trading at 10% or higher discounts, in my experience, the highest returning funds typically trade in the range of 5% discounts to 5% premiums. That said, some well known funds trade at 20% or higher premiums. Avoid them.

Three CEFs Worth Considering

Here are three municipal bond closed-end funds worth considering. All pay monthly federal-tax-free dividends.

BlackRock Investment Quality Municipal Trust (BKN): Recently traded at $17.69 per share, about a 2% premium to its net asset value (NAV). About 80% of its portfolio consists of investment grade bonds. The balance are unrated or less than investment grade (junk). Last year’s total return (dividends plus share price appreciation) was 16% and returns averaged 13% annually over the past three years. Monthly dividends equate to a 4.7% annual yield.

MainStay Defined Term Municipal Opportunities (MMD): Recently traded at $22.39 per share, about a 4% premium to its NAV. About 75% of portfolio is investment quality. Last year’s total return was 9% and total returns averaged 11% annually over the past three years. Dividend yield is 4.6%.

Nuveen Municipal High Income Opportunity (NMZ): Recently traded at $14.60 per share, a 1% premium to its NAV. About 50% of portfolio is comprised on investment quality bonds and the balance are either junk rated or unrated. Returned 7% last year and averaged 10% annually over three years. Dividend yield is 5.2%.

The main risk in holding these funds would be sharply rising general interest rates. As always, do your own due diligence. The more you know about your holdings, the better your results.

Published 2/8/21

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