Municipal bonds are a traditional go-to for retirement investors, offering the potential for reliable income plus (in many cases) significant tax savings as well. The trouble is, muni bonds are hard for individual investors to access directly or efficiently, which is why most people invest in municipal bond funds instead. But not everyone is aware that they can choose between two different kinds of muni funds: Open-end funds (traditional mutual funds) and closed-end funds. Both types of funds offer easy diversification and access to professional management. However, closed-end funds offer several unique features-including the ability to use leverage. For muni investors, leverage may be a tool that's worth learning more about.
Why income investors still love municipal bonds
It's easy to see why municipal bonds remain a favorite for income investors. Compared to other asset classes, they may produce relatively high-risk-adjusted returns with relatively low volatility. In fact, over a 20-year period, a hypothetical portfolio made up of 60% stocks and 40% municipal bonds would have returned higher after-tax performance than a 100% stock portfolio - with less risk. Despite getting some negative press a few years ago, municipal defaults (outside of Puerto Rico) are at their lowest pace since before the financial crisis, and more muni bonds are receiving upgrades than downgrades at the moment. Last but not least, many muni bonds offer yields that are free of state, federal or AMT taxes, so investors keep more of what they earn.
Unfortunately, investing in muni bonds is not an easy DIY project. With literally tens of thousands of issuers, the bonds are difficult to keep track of and research. Credit quality varies tremendously, and so does yield. Municipal bonds are also fairly illiquid; they aren't sold on exchanges and must be purchased from a broker. And they are often too expensive for the average investors to be able to afford enough to bundle together in a well-diversified portfolio.
In many ways, closed-end funds seem like a natural fit for the muni markets.
How leverage can help - and why it's important to understand the risks
For muni investors, the most interesting aspect of a closed-end fund may be its ability to use leverage. Leverage simply means borrowing money to invest in more securities. Many muni closed-end funds borrow by issuing municipal-rate preferred stock, then using the proceeds to purchase additional long-term bonds. As long as the short-term rates that the fund pays to borrow are lower than the long-term rates that the fund earns on its investments, leverage can enhance returns. That can be a compelling advantage, especially for retirement investors who want to earn high, predictable income streams.
There are some tradeoffs to consider. Leverage tends to magnify fund performance in both directions, producing higher highs but also lower lows. Swings in the fund's share price are likely to be wider. Income may be higher than it would be otherwise, but it can also be cut if short-term rate hikes make borrowing too expensive.
Today, investors are eager to explore new avenues for diversifying their portfolios and finding better ways to enhance their income. Municipal bonds have weathered many storms, including short-term interest rate hikes sharper than the ones we are experiencing now. And closed-end funds have been used for many years to pursue high, steady income for retirees. Munis and leveraged closed-end funds seem like a logical combination, and deserve a closer look by income-minded investors.