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Today’s difficult economic climate has been rough on income investors. Investors who at one time could get competitive rates from US Treasury bills and CDs are now forced out into the larger markets in search of the elusive yield. One place where many investors find themselves is in the world of closed-end funds (CEFs). Presently, the CEF universe is pretty big and there are several different kinds of CEFs, but one of the most popular types are the tax-free municipal funds. It is really no surprise as tax-free income flows appeal to all types of investors. Also with the notion that interest rates will be held low for years to come and the ever-present threat of tax increases, it is not hard to see the appeal of these investment vehicles. In the end, though, there are definite advantages and risks that one must be aware of before one decides to invest in any of these funds as opposed to holding the actual municipal bonds themselves.
Advantages
Since CEFs trade like any stock, there is really no minimal dollar threshold one has to commit to except for the price per share of the CEF. If one were to invest in the actual municipal bond, the minimum purchase price will be $5,000 while others can be up to $100,000. When purchasing the CEF, you could purchase as many shares as you would want.
Most of the municipal CEFs pay out dividends on a monthly basis, which makes for a nice income stream. If one held the actual municipal bonds, then the distributions would only come semiannually.
By buying the CEF, one gets to enjoy asset diversification as the fund will hold a wide variety of bonds within the portfolio. To try to replicate this diversification would be cost prohibitive if one were to invest directly in the actual bonds themselves.
CEFs tend to be much more liquid when it comes time to sell the shares, rather than holding the actual municipal bonds. Since the CEF shares trade on major exchanges and trade like stocks, one can easily exit a position much quicker than if one held a bond. It should be noted that even though CEFs are more liquid than actual bonds, there exist instances where some CEFs might experience liquidity problems as the final factor is basically driven by market demand for the specific equity in question.
Finally we come to the term leverage. Leverage is actually a double-edged sword, but in this section we will focus on the positives. The firm that runs the CEF oftentimes has the ability to issue preferred shares or borrow funds against the portfolio to buy more assets to get higher yields for investors. If successful, the CEF is able to return outsized tax-free yields to investors that are truly outstanding. If one held the individual bonds, one would not be able to duplicate this leverage on any meaningful level.
Disadvantages
When one buys a CEF, one will be assessed management and other administrative fees. Depending on how actively managed the fund is, these fees can really eat into shareholder distributions. If one decides to invest in individual tax-free bonds, one can fall back on the notion that one should receive 100% of par value of the bond value once it reaches the maturity date. CEFs do not have maturity dates so there is no guarantee that you will get back your initial investment amount.
Another disadvantage deals with risks related to the net asset value (NAV) of the fund. Many CEFs can be actively managed and therefore can and will have all kinds of strategies and unique investing practices in place. That means the holdings of a CEF are often unknown to the investing public at all times. That being the case, CEFs will often trade in a wide range when compared to their NAV. The end result can be that the price per share of the CEF could be trading at a large discount to the NAV of the fund. On the other hand, if one was not careful, one could easily buy into a CEF that is trading at a premium to NAV and overpay for the shares.
Our last issue is related to leverage. If a CEF is going to use leverage to get outsized yields, it's also putting itself at risk. For example, if the CEF is leveraged using debt and is borrowing using short term rates, and rates move up, the CEF will find itself more exposed than those who do not use leverage. You should be aware that this increases the risks to the investor.
All that being noted, below are some of the most popular tax-free municipal bond CEFs that are currently available. Some will use leverage while others steer clear of the practice. Finally, take note that for each fund I give a taxable equivalent yield figure which represents the yield one would need to get on a taxable investment to equal the tax-free yield on the CEF in question. I used a 35% federal tax rate and took no consideration to any applicable state taxes.
Nuveen Municipal Value Fund (NUV) is a closed-ended fixed income mutual fund launched by Nuveen Investments, Inc. The fund is managed by Nuveen Asset Management. It invests in the fixed income markets of the United States. The fund also invests some portion of its portfolio in derivative instruments. It invests in undervalued municipal securities and other related investments the income, exempt from regular federal income taxes that are rated Baa or BBB or better. It employs fundamental analysis with bottom-up stock picking approach to create its portfolio. The fund benchmarks the performance of its portfolio against the Standard & Poor’s (S&P) National Municipal Bond Index. Nuveen Municipal Value Fund, Inc. was formed on April 8, 1987 and is domiciled in the United States.
Net Asset Value$1,902M
Premium/Discount-1.36%
Yield4.95%
Taxable Equiv. Yield7.61%
Leverage %0%
Yield FrequencyMonthly
[Click all to enlarge]

Nuveen Premium Income Municipal Fund 2 (NPM) operates as a closed-ended mutual fund launched by Nuveen Investments Inc. It is managed by Nuveen Asset Management. The fund invests in a diversified portfolio of municipal obligations issued by state and local government authorities. Its investment portfolio includes investments in the U.S. guaranteed obligations and tax obligations, as well as in the healthcare, transportation, utilities, education and civic organizations, consumer staples, housing/multifamily, and water and sewer sectors. Nuveen Premium Income Municipal Fund 2 was founded in 1991 and is domiciled in the United States.
Net Asset Value$1,520M
Premium/Discount-4.31%
Yield6.69%
Taxable Equiv. Yield10.29%
Leverage %32%
Yield FrequencyMonthly
MuniYield Quality Fund III (MYI) is a BlackRock (NYSE:BLK) closed-end fund that seeks to provide shareholders with as high a level of current income exempt from federal income taxes as is consistent with its investment policies and prudent investment management. The fund invests primarily in a portfolio of long-term, investment-grade municipal obligations the interest on which, in the opinion of bond counsel to the issuer, is exempt from federal income taxes.
Net Asset Value$1,271M
Premium/Discount-5.47%
Yield6.75%
Taxable Equiv. Yield10.38%
Leverage %28%
Yield FrequencyMonthly

Nuveen Select Tax-Free Income Portfolio
(NXP) is an exchange traded fund launched by Nuveen Investments, Inc. It is managed by Nuveen Asset Management Inc. The fund invests in the fixed income markets of the United States. It primarily invests in long-term municipal obligations with investment-grade ratings (Baa and BBB or better). Nuveen Select Tax-Free Income Portfolio was formed on March 19, 1992 and is domiciled in United States.
Net Asset Value$230M
Premium/Discount-0.57%
Yield5.16%
Taxable Equiv. Yield7.93%
Leverage %0%
Yield FrequencyMonthly
PIMCO Municipal Income Fund II (PML) is a mutual fund launched and managed by Allianz Global Investors Fund Management LLC. The fund is co-managed by Pacific Investment Management Company LLC. It operates as a closed-end management investment company. The fund invests primarily in municipal bonds, variable rate notes, variable rate demand notes, and U.S. treasury bills. PIMCO Municipal Income Fund II was formed in 2002 and is domiciled in United States.
Net Asset Value$999M
Premium/Discount1.15%
Yield7.36%
Taxable Equiv. Yield11.32%
Leverage %36.72%
Yield FrequencyMonthly

Eaton Vance Insured Municipal Bond Fund
(EIM) is a close-ended equity mutual fund launched and managed by Eaton Vance Management. It invests primarily in high grade municipal obligations. The fund’s investment portfolio primarily includes investments in companies operating in the transportation, water and sewer, and electric utilities sectors. Eaton Vance Insured Municipal Bond Fund was founded in 2002 and is based in Boston, Massachusetts.
Net Asset Value$831M
Premium/Discount-4.20%
Yield7.87%
Taxable Equiv. Yield12.11%
Leverage %42.6%
Yield FrequencyMonthly

Dreyfus Strategic Municipals, Inc.
(LEO) operates as a diversified, closed-end management investment company. The fund invests primarily in municipal obligations of various states of the United States. The Dreyfus Corporation serves as the investment adviser of the fund. Dreyfus Strategic Municipals was founded in 1987 and is based in New York City.
Net Asset Value$737M
Premium/Discount-1.82%
Yield7.28%
Taxable Equiv. Yield11.20%
Leverage %31.68%
Yield FrequencyMonthly

Van Kampen Trust for Investment Grade Municipals
(VGM) is a close-ended mutual fund launched by Van Kampen Investments, Inc. The fund is managed by Van Kampen Asset Management. It operates as a diversified, closed-end management investment company. It invests primarily in municipal securities rated investment grade. Its investment portfolio comprises various sectors, such as general purpose, hospital, public education, public building, and wholesale. Van Kampen Trust For Investment Grade Municipals was founded in 1991 and is based in New York City.
Net Asset Value$1,097M
Premium/Discount-0.43%
Yield7.64%
Taxable Equiv. Yield11.75%
Leverage %31.71%
Yield FrequencyMonthly


Disclosure: I am long NUV.
Source: Tax-Free Investing Using Closed-End Funds