Many investors turn to municipal bonds in their retirement years because of the potential for reliable income and (in many cases) significant tax savings too. Generally, individual investors can find muni bonds more difficult to access directly or efficiently, which is why most people invest in municipal bond funds instead.
But it becomes important to know that there are two different kinds of muni funds: open-end funds (traditional mutual funds) and closed-end funds. Both offer easy diversification and access to professional management. But closed-end funds offer several unique features—including the ability to use leverage. For muni investors, leverage may be a tool worth learning more about.
Why income investors love municipal bonds
It’s easy to understand why municipal bonds are attractive to income investors. Many of these muni bonds offer income free of state, federal and AMT taxes. It’s always nice to keep more of what you earn. And compared to other asset classes, they can produce relatively high risk adjusted returns with relatively low volatility. In fact, over a 20-year period, a hypothetical portfolio made up of 60% stocks and 40% municipal bonds would have returned higher after-tax performance than a 100% stock portfolio—with less risk.
Unfortunately, investing in individual muni bonds can be quite a challenge. It’s difficult to keep track of and research thousands of bond issuers. Yield varies, as does credit quality. Municipal bonds are also fairly illiquid; they aren’t sold on exchanges and have to be purchased from a broker. Many times they are expensive for the average investors to bundle into a well-diversified portfolio.
Closed-end funds can be an attractive alternative when investing in muni bonds.
Closed-end funds:
• Offer instant diversification with a single investment
• Are usually actively managed, which enables them to tap into the expertise of professionals in sorting out credit quality and ameliorating market and pricing inefficiencies
• Are traded on exchanges, like stocks, so portfolio managers don’t need to deal with constant inflows and outflows of cash from shareholders buying and redeeming shares
• Have a fairly stable pool of assets, making it easier for them to invest in less-liquid assets like municipal bonds
How leverage can help—and why it’s important to understand the risks
For muni investors, the most interesting aspect of a closed-end fund may be its ability to use leverage. Leverage simply means borrowing to invest in more securities. As long as the short-term rates that the fund pays to borrowers are lower than the long-term rates that the fund earns on its investments, leverage can enhance returns. That can be a compelling advantage, especially for retirement investors who want to earn high, predictable income streams. There are some tradeoffs to consider. Leverage tends to magnify fund performance in both directions, producing higher highs but also lower lows. Swings in the fund’s share price are likely to be wider. Income may be higher than it would be otherwise, but it can also be cut if short-term rate hikes make borrowing too expensive.
Time, however is also important—over a longer period, such as three or five years, leverage his historically delivered incremental income that more than compensated for the associated cost and added volatility. The following graph demonstrates this concept, using hypothetical returns and average costs based on municipal bond market indexes.
Today, investors are eager to explore new avenues for diversifying their portfolios and finding better ways to enhance their income. Municipal bonds have weathered many storms and closed-end funds have been used for many years to pursue high, steady income for retirees. Munis and leveraged closed-end funds seem like a logical combination and deserve a closer look by income-minded investors.