Tax-Free Income on Sale: Buying Municipal Bonds at a Discount with Closed-End Funds

With exchange-traded funds (ETFs) taking the investment world by storm, it’s easy to forget that there are other ways for investors to get their asset allocations and buy asset classes, including the humble closed-end funds (CEFs). CEFs are the first type of fund ever created in the United States and predate mutual funds by decades.

CEFs are issued in a fixed number of shares at an IPO. The proceeds are then used by managers to buy various assets according to their mandate. However, unlike mutual funds or ETFs, there is no creation of additional shares with CEFs. To buy them, their shares trade on the major exchanges. Their share prices are dictated by supply and demand. So, this fact can cause them to trade at discounts or premiums to their so-called net asset values. And because they are allowed a little leverage, they can juice their assets and returns.

Because managers of CEFs don’t need to worry about investor exchanges or sales – these happen in the secondary market – CEFs have long been a wonderful structure for illiquid asset classes, strategies and long-term focus. For the most part, municipal bonds are long dated securities, with many buyers holding until maturity, which make them perfect for the CEF structure. According to Nuveen’s CEFConnect, there are over 110 different muni CEFs holding muni bonds.

And there could be current opportunities in those funds for investors today.

Munis longer durations haven’t fared well over the last year. As bond Armageddon has taken place and the Fed has gone from 0% interest rates to over 5%, long dated bonds have suffered immensely. The Bloomberg Municipal Bond Index sank and posted a negative 8.5% return last year, the worst on record since 1981. Muni CEFs did even worse, thanks to their leverage and other factors; the average fund lost 24.4% on market price.

But that loss has created an interesting turn of events for investors. As we said, the share price of a CEF has nothing to do with its value, and often they can trade at discounts to NAV, allowing investors to buy $1 worth of bonds for 90 cents. And that is exactly what has happened today. We have share prices dropping further than the assets they hold.

The discount is now at some of the widest levels in nearly two decades. According to data provided by Matisse Capital, the average muni CEF is trading at an 11% discount to its NAV. This compares to the long-term average of 4% and the 1.5% discount on the funds at the beginning of 2022.

The effect of the discount/falling share price also helps on the yield front. Because of their use of slight leverage, muni CEFs often yield more than a regular ETF or mutual fund. But as the share price dips, the yield gets larger. Today, the average muni is paying a tax equivalent distribution rate of 6.9%. That’s almost two full percentage points higher than the yield on a muni bond mutual fund.

Investors today can buy assets for a discount to what they are worth and score a high tax-free yield by using the structure.

Be sure to check Municipal Bonds page to explore all muni bond mutual funds, index and active ETFs.

Nothing can be as simple as it seems and Uncle Sam does have a way to tax for muni investors. This comes courtesy of an obscure section of the Internal Revenue Code called the de minimis tax rule. Basically, the de minimis rule determines whether the price appreciation of a muni security purchased at a discount will be taxed as ordinary income or the capital gains. The IRS formula uses par value minus full years to maturity x 0.25% to determine the threshold.

Now, there are few things to keep in mind. As for the CEFs themselves, investors are buying the fund at a discount to its net asset value. Whether or not the bonds inside the CEF are trading below par is a different matter. Secondly, many good muni managers will only purchase bonds at premiums or only slight discounts to face value- both PIMCO & Nuveen explicitly state they will do so for many of their funds. And in fact, much of the investment grade muni world tends to trade well above the de minimis thresholds anyway. So, what really happened over the last year was bonds going from premiums to only slightly below face value.

So, could the de minimis rule happen to your CEF investment? Sure. But for the vast bulk of investors, this isn’t the case. And unless you’re in the very top tier tax brackets, it’s not necessarily a concern.

As if the discount and high yield wasn’t enough, BlackRock suggests that any time the sector has massive discounts of 10% or more, muni CEFs have plenty of total return as discounts return to norms over the next couple of quarters. So, the time to buy is now.

But, what to buy?

Some of the best and largest CEFs in the space are run by Nuveen, Blackrock and Eaton Vance. The key for investors is to find funds with large trading volumes, good discounts to NAV and large asset bases. Smaller CEFS will often be merged into larger funds after a certain time. A quick screen produces the Nuveen Municipal Value Fund (NUV), BlackRock MuniYield Quality Fund (MQY) and Eaton Vance Municipal Income Trust (EVN) all trade at big discounts to the values and offer current yields in excess of 7%. But there are plenty of other top choices from these and other fund families.

Another interesting choice could be ETFs. The VanEck CEF Muni Income ETF (XMPT) is an ETF that tracks an index of muni bond CEFs. With XMPT, investors get exposure to 56 different muni CEFs. In exchange for the broad exposure, however, investors give up some yield, with the ETF yielding 4.45%. But it could be an easy way to gain exposure. Likewise, the active Saba Closed-End Funds ETF (CEFS) includes some muni exposure to its holdings, but it’s not a pure vehicle.

Munis have been hit hard as the Fed raised rates. But that dip has provided plenty of opportunity; particularly, if investors are willing to look outside the box. With muni closed-end funds, investors are able to score assets for pennies on the dollar and boost their taxable equivalent yield close to 7%, which is a wonderful deal that won’t last forever.