Muni Bond CEFs: Beware the Leverage

by: Roger Nusbaum

Roger Nusbaum submits: A reader asked for my opinion on these as he is considering buying a couple for his Mom for tax free income. A few points come to mind along with a question or two.

Most, not all, Muni CEFs use leverage. If the curve normalizes and rates in the middle of the curve go up later in the decade (both reasonable possibilities), these funds will get hit to some degree.

Also there will be the occasional shock to the bond market. About the worst of these was in summer 2003. It might be worthwhile to see how a given fund did during that time period.

This chart shows the Nuveen Arizona Premium Income Municipal Fund (NYSE:NAZ) during that time period. The fund, as funds go, got crushed, dropping about $2 per share in a few weeks:

There is no way to know what will happen the next time there is a bond market crisis, but this can be a constructive exercise.

The funds with leverage would obviously be riskier bets. I don't have any of these for clients but owning this part of the market is some small measure within a diversified bond portfolio is probably OK, but to be clear I have no interest in these. If I know a client can hold to maturity I prefer individual issues, all of the past caveats about slippage notwithstanding.

The reader mentions something about being more interested in funds with discounts. I think they all trade at discounts, or it seems like they do. A discount is better than a premium but I would not expect the discount to close in a meaningful way ever. If it does, great but I would not expect it.

As far as a question from me, are you sure tax-free income for a retired person is necessary? The yield could be favorable, of course, but a lot of people have less income in retirement and so tax free yield may not be the best thing.

I don't know what is right for the reader's mother of course but that is the question I would ask.