Recent interest rate hikes have led to a decline in municipal bond prices, creating attractive tax-free income opportunities for investors, particularly those in higher tax brackets. While closed-end funds offer compelling yields and leverage for potentially enhanced returns, they come with increased volatility and higher fees. Alternatively, individual laddered municipal bonds provide simplicity for those with significant capital, while ETFs offer diversified exposure with lower entry barriers, though investors must carefully consider interest rate risk across all options.
The recent surge in interest rates has significantly impacted municipal bond prices, creating a compelling opportunity for investors seeking attractive tax-free income within this specific market segment. According to Nuveen, municipal bonds recorded a negative return of 6.35% in the third quarter, marking their most challenging quarter since 1981. This downturn was largely attributed to a sharp spike in rates rather than any underlying credit deterioration.
As bond yields and prices move inversely, this period of lower prices has translated into heightened income generation potential. By early October, the yield on the Bloomberg Municipal Bond Index had climbed to 4.78%. "What that's provided, in our view, is a very good opportunity set," stated 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." Close also highlighted the renewed focus on a "higher for longer" interest rate environment, with market expectations now pointing to a greater likelihood of the Federal Reserve implementing another rate hike in December, with CME FedWatch tools suggesting approximately a 71% probability.
The recent dip in muni bond valuations is particularly appealing for high-income investors, who benefit substantially from their tax-exempt status at the federal level. For those residing in the issuing state, these bonds typically offer tax-free income at both state and local levels as well. To illustrate, an investor in the 32% marginal federal income tax bracket, also subject to the 3.8% net investment income tax, would find a muni bond yielding 3.5% comparable to a taxable bond yielding 5.45%, according to New York Life Investment Management. Several options exist for tapping into this market, and for those comfortable with volatility and eyeing substantial yields, closed-end funds (CEFs) can provide a compelling income stream, albeit with added complexity.
Understanding Closed-End Funds
Closed-end funds differentiate themselves from open-ended mutual funds and exchange-traded funds (ETFs) in several critical ways. Firstly, CEFs have a fixed number of shares that trade throughout the day on a stock exchange, often at a premium or discount to their net asset value (NAV). Secondly, CEFs frequently utilize leverage, a strategy that can enhance returns over time but also introduces increased price volatility, including the potential to magnify losses. Lastly, CEFs typically incur higher fees compared to their ETF counterparts. This is because they are actively managed, and the use of leverage adds to operational expenses, with expense ratios sometimes exceeding 1%, which can erode investor returns.
Investors in municipal bond CEFs continue to receive monthly tax-free income, which may derive from a combination of interest payments, realized capital gains from the sale of underlying holdings, and occasionally, a return of capital. For example, Nuveen's Quality Municipal Income Fund (NAD) currently offers a distribution rate of 8.2% and trades at a 3.64% discount to NAV. Similarly, BlackRock's MuniHoldings Fund (MHD) provides a 6.79% distribution rate and sells at a 9% discount.
"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," noted Close at Nuveen. However, investors must be fully aware of the trade-offs. Tyler McConville, CFP and private wealth advisor at The Capital Group, cautions, "Most of our clients are retirees whose priority is generating tax-efficient income and managing risk. 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 Bonds and ETFs for Diversification
For investors prioritizing simplicity and possessing sufficient capital, constructing a portfolio of laddered municipal bonds offers a way to manage the risk associated with rising interest rates. This strategy involves acquiring bonds with varying maturities and then reinvesting the proceeds into new issues as older holdings mature. "I can match cash needs and hold to maturity, and many investors find that reassuring," explained Eileen Olson, CFP and founder of Emerald Wealth. The primary challenge with this approach is the substantial pool of money required to build a truly diversified muni portfolio, with Olson estimating a minimum of $250,000 for clients.
For those with more modest savings, an ETF can provide broad diversification without the need for extensive capital. However, investors must recognize that ETFs will experience price fluctuations as rates move, and they should carefully consider interest rate risk, or duration, when selecting a fund. Vanguard offers an actively-managed Core Tax-Exempt Bond ETF (VCRM), which has an average duration of 7.5 years and a 30-day SEC yield of 4.49%. Among the largest muni bond funds by assets are 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," commented Matthew Wrzesniewsky, Vanguard's head of fixed income client portfolio management. His team expresses a preference for the intermediate portion of the muni yield curve. "Those windows of opportunity have opened up, and we're still there," Wrzesniewsky concluded.
