If you're considering investing in municipal bonds for tax-free income, there are a few things you need to know. Let's start with some not-so-great news: currently, the main muni index yields just 3.1% - not exactly an enticing offer compared to the 5% yield in a money-market fund.
However, despite this, many investment strategists still see value in the safety of the asset class. In fact, for individuals in higher tax brackets and high-tax states, that 3.5% yield can be equivalent to a 6% taxable yield. So if the stock market becomes overvalued and the economy starts to soften, that secure 6% starts to look pretty attractive.
Analysts predict a 6% gain for the S&P 500 index in 2024, and we're already halfway there. If the economy weakens, interest rates are likely to fall, creating gains for municipal bonds as bond prices move inversely to interest rates.
So how can you nudge muni-bond yields even higher? One strategy is to stretch out maturities to the 12-18 year range. This offers more attractive spreads over Treasuries on an after-tax basis. Another option is to explore closed-end muni funds and high-yield muni portfolios for an income boost over the index.
In particular, closed-end muni funds are currently trading at unusually large discounts to their net asset values. Research from Matisse Funds indicates that the average muni closed-end fund now trades at a 12.6% discount, compared to a long-term average discount of 4.1%. This makes it a "generational moment" for the asset class, according to a recent Matisse report.
So if you're looking for tax-free income and are willing to explore different strategies, municipal bonds can offer a compelling opportunity. With the potential for higher yields and additional income boosts from closed-end muni funds, it's worth considering as part of your investment portfolio.
Muni Closed-End Funds: A Top Pick for Income
A head of macro strategy at Academy Securities, Peter Tchir, believes that muni closed-end funds are the top choice for income this year. These funds offer higher yields thanks to leverage, and when the Federal Reserve cuts rates, that leverage becomes cheaper for the funds. This can potentially lead to higher payouts and narrower discounts.
Tchir states that while the buying opportunity in closed-ends was considered "insane" in October, it still remains attractive. He advises investors to buy on dips and diversify their portfolio across a basket of muni closed-end funds. An example is the Nuveen AMT-Free Quality Municipal Income fund, which currently yields 4.7% or about 7.5% on a tax-equivalent basis, and is trading at a discount of 15%.
Nisha Patel, a managing director in the municipal bond group at Parametric, highlights that rate risk is currently asymmetric in munis, especially for investors who utilize a tax-loss harvesting solution. If rates rise one percentage point in the next year, an A-rated muni portfolio would only lose 3.7%, or 1% with the benefit of harvesting tax losses. However, if rates were to fall by one point, the same portfolio would see a return of 12%.
For those seeking a flexible strategy, Sean Carney, head of municipal strategy at BlackRock suggests considering their firm's Strategic Municipal Opportunities fund. This fund allows investors to take advantage of various opportunities across munis as specialists decide when and how to dip into weaker credits or different sectors of the market.
Carney also mentions that investors who are currently overweight on cash could move into munis to secure "some durable yield that is going to be there for many years."
Though closed-end funds pose more risk due to leverage, tax-equivalent yields can reach up to 8%, according to Jim Robinson, the manager of the Robinson Tax Advantaged Income fund, which is composed of closed-end funds. He adds that the confidence lies in knowing that the best municipal portfolio managers are running these funds.