Seeking Tax-Free Income From Closed-End Funds
by Michael Walters and John Deysher
Four years ago we wrote an article for the AAII Journal highlighting the potential opportunities available in closed-end funds (“Rodney Dangerfield Investing: Closed-End Opportunities,” April 2007).
We think now is a good time to revisit the topic, with a focus on municipal bond closed-end funds (CEFs) and their newer cousins, municipal bond exchange-traded funds (ETFs).
In this article
- Why Consider Municipal Bonds Now?
- No Free Lunch
- The Big Three: Basic Differences
- Scrutinizing Closed-End Municipal Bond Funds
- More Information on Closed-End Funds
- A Word About Leverage
- Are Municipal Bond ETFs a Better Alternative?
- Conclusion
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Why Consider Municipal Bonds Now?
With most world equity markets near record highs and interest rates near record lows, why consider municipal bonds (aka “munis”)? There are several reasons.
First, municipal bonds remain the only game in town for capturing tax-free income. Municipalities must have a way to compete for investor capital, and keeping their interest tax-free (in most cases) accomplishes this. Other vehicles such as IRAs or tax-deferred annuities allow income to accumulate tax-free, but Uncle Sam must be paid upon withdrawal. There are also limits to what you can put in a retirement plan and lockups on annuities.
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John Deysher is president and portfolio manager of the Pinnacle Value Fund, a diversified, SEC-registered mutual fund specializing in the securities of small and micro-cap firms. He is a CFA charterholder and has managed equity portfolios for over 25 years. He lives and works in New York City and may be reached at deysher@pinnaclevaluefund.com.
Discussion
I have owned several tax free closed end bond funds all of which are currently below purchase price ranging from 5% to 20%. Although the income averages around 6%, they do fluctuate rapidly at times. I'm concerned that rising interest rates which appear inevitable may cause further declines in NAV.
I have been slowly consolidating these holdings as they ecompass approximaely 65% of our total assets.
posted about 1 year ago by Joseph from Washington
Closed end funds can be an excellent income producing vehicle, but you should always take the time to perform your due diligence....remember you are never married to any fund.
posted about 1 year ago by Mark from New York
Thanks for the article; I had not heard of the leverage in closed end funds having the effect of lengthening the bond duration. It makes sense and will help me next time I look at closed end funds.
It would have been helpful to include some explanation of how the AMT relates to muni income--with some funds being AMT free.
posted about 1 year ago by Tyler from California
I would also like to hear about which ETFs and CEFs avoid AMT.
posted about 1 year ago by Michael from California
For each of the above you say tax free.
What % is for Pa. or any other state,?
posted about 1 year ago by Richard from Pennsylvania
How do you calculate the change in duration due to leverage?
posted about 1 year ago by Charles from District of Columbia
Why would anyone want to purchase muni bonds through a fund?
posted about 1 year ago by Joseph from Kansas
