Investors Battered by Closed-End Muni Funds

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<h3>James A. Klotz</h3>

James A. Klotz

It’s a challenging time for investors in closed-end municipal bond funds.

The combination of rising interest rates and the structure of the funds themselves are clobbering their returns.

If this sounds familiar, it should be, as closed-end muni fund investors were caught in a similar predicament during the Great Recession (“Investors Get Short End With Closed-End Funds”).

Investors battered by closed-end muni funds

Borrowed money

Closed-end municipal bond funds typically use leverage – borrowed money – to invest in munis. In this way, it is possible for funds to generate higher yields than the securities they hold.

As we said back in 2008, we are leery of that practice. When yields are rising and prices are declining, as we are experiencing today, closed-end funds generally perform poorly.

In the first three quarters of 2023, municipal bond closed-end funds returned an average of negative 7.69%, which includes prices changes and distribution payments, according to The Wall Street Journal.

Rates, structure are the culprits

The problem for closed-end muni funds is twofold: First, rising interest rates mean it’s more expensive for funds to borrow the short-term cash they use to invest in long-term bonds. Second, closed-end funds issue a fixed number of common shares. Investors trade shares between themselves, so funds tend to have limited cash to add newer, high-yielding bonds that would make the funds more appealing to new investors.

“Munis have this double whammy,” a closed-end fund strategist told the Journal. “Their borrowing costs have gone up, their underlying bonds have gone down and the combination of that is what’s crushing them.”

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    Dozens of funds have cut their monthly distributions – many more than once – over the past two years. “For some funds, those payments are now approaching crisis-era levels,” the Journal said.

    Peaceful returns

    As a municipal bond firm that has served generations of families, we invariably recommend investors select their own tax-free bonds with the assistance of a specialist. Today’s market illustrates an important reason why.

    With individual bonds, you reap a steady stream of predictable, call-protected, well-diversified tax-free income. They are especially attractive today as yields scrape yearslong highs (“Individuals Pouncing on Munis ‘Priced to Perfection’).

    Of course, individual bond investors know the price of their bonds will sometimes be higher than they paid for them, and sometimes lower.

    But unlike bond funds, individual bonds have a stated maturity date and a promise to return principal at maturity or when called, features that will, in turn, help you enjoy a good night’s sleep.

    James A. Klotz is the President of FMSbonds, Inc.
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    Oct 18, 2023

    Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.