Tax season was a little more painful than usual this year.
I sold some stock positions that I’d held for years and that had accumulated large capital gains. So, when I filed my tax return, I had to write a very large check I didn’t want to write.
I know I shouldn’t complain. After all, if I’m paying taxes, that means I’m making money. But it can still come as a kick to the teeth to give Uncle Sam his cut.
I’ve made no secret of my visceral hatred of paying taxes. As I’ve written before, in my 20s I was known to skip meals to free up cash to dump into my 401(k) plan and lower my tax bill.
Thankfully, I don’t have to go to those lengths anymore. But I’m still fanatical about using every legally available loophole I can to lower my tax bill (see “Here’s a Few Ways to Stick it to the Tax Man”).
It’s never too early to start planning for the next tax year, and today I’m going to share with you one of my very favorite ways to earn a tax-free buck via closed-end municipal bond funds.
If you unfamiliar with closed-end funds (CEFs), they are a type of mutual fund that trades on the New York Stock Exchange. But unlike that other type of mutual fund that trades in the public exchanges – ETFs – CEFs don’t generally track an index.
And also unlike ETFs, CEF shares generally cannot be created or destroyed by large institutional investors. As a result, CEF market prices will often deviate wildly from the value of their underlying portfolios.
This is precisely what makes them so much fun. If you’re patient and wait for your opportunities, you can often buy a dollar’s worth of quality assets for 90 cents or less. This is precisely the case today in the muni CEF market.
Many of the largest and most liquid muni CEFs are trading at 10% to 12% discounts to net asset value (NAV).
The return you get in a CEF comes from three possible sources:
- The current yield. CEFs tend to be income-focused and pay high yields. Today, yields of 5% to 6% are common among muni funds. And remember, that yield is tax-free!
- Appreciation in the underlying portfolio. Like any mutual fund, CEFs hold marketable securities like stocks and bonds. When the value of those assets rise, the net asset value of the fund rises too.
- Changes in the discount or premium to NAV. This is where it gets fun. CEFs normally trade at modest discounts to NAV. But sometimes, investors get irrationally scared and push the share prices lower, which widens the discount to NAV to abnormally high levels. This creates fantastic opportunities for prices to “snap back” to more typical discounts to NAV.
So, how do muni CEFs as a sector stack up today?
The current yield is easy enough to understand. Most muni CEFs pay in the ballpark of a 5% to 6% dividend at current prices. But if you’re in the 32% tax bracket, that 5% to 6% yield is the equivalent of a taxable 7.4% to 8.8%.
These are conservative muni bonds issued by state and local governments. You’re not going to find a yield anywhere close to that high anywhere else, at least not without taking a lot more risk.
I have milder expectations for appreciation of the bond portfolios. I think it’s likely bond yields drift lower from current levels, but I don’t see that adding more than a couple percent to returns.
Now, the change in the discount to NAV is where the kicker comes in. If recent history is any guide, the 10% to 12% discounts available today should shrink to 3% to 4% as yield-starved investors trickle back into the sector.
So, between the 7.4% to 8.8% in tax-equivalent yield, a percent or two from portfolio appreciation, and another 7% to 8% from a shrinkage in the discount to NAV… you’re looking at the potential for returns of close to 20% over the next year or so. That’s not too shabby for boring muni bonds.
Out of fairness to my paying subscribers, I can’t share with you the names of the specific muni CEFs I recommend in my income-based newsletter, Peak Income. But if you’re looking for solid returns that won’t leave you with a large tax bill, I recommend you give the sector, and my service, a deeper look.