Muni CEFs Vs. Bonds: Which Is Better?

 |  Includes: IBME, MUA, MUB, NEA, NMZ, NZF, SHM, VMO
by: Mike the PhD

Muni Bond CEFs: What Are the Best Sources of Tax-Free Income?

In a past article, I wrote a basic overview of municipal bonds, and I explained that municipal bonds are characterized by three important traits.

(1.) They are federally (and sometimes state) tax free

(2.) They rarely default (if you stay away from certain categories of munis)

(3.) They are highly illiquid, and have prohibitive transactions fees.

Today, I want to talk about a solution to this third point.

To begin with muni bonds are very illiquid. If you want to buy a muni bond, you have to call your broker, and they can only sell you bonds they have "in stock," meaning held by their institutional investing desk at that time. So if you want bonds issued by the City of Cleveland, that will mature in 2023, chances are you are out of luck. The bonds probably exist, there just aren't very many of them relatively speaking so it's hard to find someone looking to sell them.

In addition, assuming your broker has muni bonds you are interested in, you will most likely want to buy less than $1 million of those particular bonds. Since you want to buy less than $1mm, you will have to buy the bonds from the firm's retail bond desk rather than their institutional bond desk, and you will get ripped off on the transactions costs. Trust me, I know - I worked on the institutional trading desk for a major securities firm for several years before I became Mike the PhD. The prices we sold bonds to other institutional investors for were considerably lower than the prices retail investors (a.k.a. individual investors) paid.

The real transaction cost in buying a bond isn't in the broker's commission (usually). It's in the markup of the bond that you never see. A bond might be trading at a par value of 100 between different institutions, but if a retail investor wants to buy that bond, the bank will mark it up to 105 commonly. Since the price of the bond goes up, the yield goes down. What you really need is a list of what bonds the broker has and what they are trading for currently. In theory you can get this from a regulatory body called the MSRB, but in reality it is way too much work and way too complex for most retail investors to do this.

So now you have a problem. Your brokerage firm will rip you off if you try to buy an individual bond and it will be very illiquid if you do buy it. What can you do? The best answer for most retail investors is to invest in various ETFs or exchange traded funds. These funds usually pay interest in the form of dividends every month, the dividends on most are income tax-free, and many have dividends that are also AMT free.

Now technically, muni funds that are traded are usually CEFs (closed end funds), rather than true ETFs, but they still trade through the exchanges and you buy and sell them like stocks, which is mostly what you probably care about. So call them exchange traded funds (they do technically trade on the exchanges and they are funds), or CEFs or whatever you'd like, but these securities can give you easy exposure to muni bonds in a liquid relatively low cost setting.

However anytime you give someone else your money and ask them to invest it, you are giving up some control and choice. In particular, you may not like the level of risk that some of the muni funds take on. Risks for these funds can come in three forms: credit risk, interest rate risk, and liquidity risk.

Liquidity risk is the least significant of these. Basically it just means that if the country's financial markets melt down again, and the fund wants to sell some of its bonds, it may have a hard time doing so. Historically this hasn't been a major cause for concern outside of the auction rate securities (ARS) markets, and maybe the tender option bond (TOB) markets. I'll write more about those markets in the future.

Credit risk is a slightly bigger concern. Defaults in municipal bonds are extremely rare. The average BBB+ muni defaults at about the same rate that AA- corporate do. (I will write more about this in a future post.) Nevertheless, if you want to be safe and avoid credit risk, just go to the fund's website and check out their holdings. They will usually tell you what percentage of their holdings are investment grade and what percentage are non-investment grade. Just make sure you are comfortable with that percentage, but again, credit risk is mainly a non-event for most muni's despite what you see periodically on the business channels. That said, if you want to be safe or you are concerned about a particular bond, it is always a good idea to ask a financial advisor for their view.

Finally, interest rate risk is a real legitimate concern. Since bond yields move in the same direction as the Fed funds rate and Treasuries (in all but the most extreme of markets anyway), and since yields and bond prices are inversely related, when the Fed raises interest rates, outstanding (a.k.a. existing) municipal bond prices will fall. If inflation picks up outstanding municipal bond prices will fall. When this happens, (notice I said when, not if, this will happen eventually in 1 year or 21 years), the value of muni CEFs will fall also.

How much will prices fall? That depends on the duration of the bonds held by the fund (and also on their convexity, but that is a secondary issue). The duration of a bond is just the weighted average of time until cash flows are to be received by the bond holder. It is also the price sensitivity of the bond to a one unit change in interest rates. (Yes, I know these are slightly different types of duration, but that's unimportant for our purposes right now.)

What this means is that a 1% rise in interest rates will cause a bond's price to drop by approximately its duration*1%. So a bond with a duration of 10 will drop 10% if interest rates rise 1%. This rule of thumb gets a little messy if interest rates rise a lot because of convexity (e.g. a 5% rise in interest rates won't lead to a 50% price drop), but again that's usually a secondary issue.

So if you want to assess the interest rate risk for a given fund, go find out what its average duration is for all of its bonds. The higher the duration, the more interest rate risk you face. If the fund is leverage, and many are, then the duration will be higher than for an unleveraged fund. (The yield will also be higher of course.)

Here is an example of the detailed holdings for a municipal bond fund from Nuveen. This detail is not proprietary, and anyone can access it through Nuveen's website. NMO yields 5.52% which for someone in the top tax bracket is roughly the equivalent of a 9% taxable yield. Similar information can be found for other CEFs simply by going to the website of the fund company. With little difficulty, I was able to find data for funds including (NMA), (NYSE:NMZ), (NYSE:VMO), and as well non-leveraged long and short term funds like (NYSEARCA:MUB), (NYSE:MUA), (NYSEARCA:SHM), and (MUAE). here

Please Note: I am not recommending or discouraging you from choosing to invest in (NMO). I don't know your personal financial situation or your risk tolerance, so I couldn't tell you if it is a good or bad investment for you personally. It's just an example, and since I am writing this all for free, I don't feel compelled to stick my neck out making a recommendation that may not be suitable for any particular individual.

In future posts, I will detail some statistical modeling I have done that allows you to predict returns for a muni bond fund if you start with some background data on it, but I think this is enough for today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.