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Closed-End Municipal Bond Funds

The days of high interest rates seem to be behind us, at least for now. This makes for some pretty lean times if you're a saver instead of a borrower. And looking across the horizon, we don't see any change coming soon. Seniors seeking income in retirement really have two choices in today's financial markets: accept lower yields or accept unbelievably lower yields.

As most investors know, returns generally increase with the amount of risk in the investment. But where do they go up from? Many financial experts consider the U.S. Treasury Note to be the starting point, virtually a risk-free investment. Investors use the yield of the U.S. Treasury Notes as a point of comparison for all other investments. If it pays more than T-Bills, and it probably will, it will also have more risk.

A little explanation about Treasury Bills and Treasury Notes:

Treasury Bills (check current rate of T-Bills by clicking here)

Treasury Bills, also called T-Bills, mature in one year or less. T-Bills are considered by many to be the absolutely most risk-free investment for investors in the U.S. They do not pay interest before they mature; rather they a sold by the government at a discount to what's known as their par value. As the T-Bills mature, they increase in value to the par value to create returns for the investor. If you're thinking this is a lot like a zero-coupon bond, you're exactly right!

Banks and large financial institutions are the largest buyers of T-Bills. However, with the creation of Treasury Direct, almost anyone can now invest in T-Bills over the internet and have the funds deposited directly into their personal bank account automatically. This will usually provide greater returns on savings.

Treasury Notes (check current rate of T-Notes by clicking here)

Treasury Notes, also called T-Notes, have longer maturation dates than T-Bills; they mature in two to ten years. Another difference, is they have an interest payment called a coupon payment every six months. They are usually sold in denominations from $1,000 to $1,000,000. Treasury Notes are the financial instrument commonly referred to when discussing the performance of the U.S. Bond Market. The rate of the 10-year T-Note is also commonly used as a reference point describing the market's outlook for longer-term economic expectations.

So if you're not satisfied with the yields provided by T-Bills and Treasury Notes, how does a wealthy senior generate income in retirement? Perhaps a closed-end municipal bond fund, commonly called muni bonds, might be the solution.

Tax Free Municipal Bonds (check current Tax Free Muni Bond Rates by clicking here)

If there was a mantra for Tax Free Municipal Bonds, it might be "It's not what you earn, it's what you keep that matters."

A municipal bond, also called a muni or muni bond, is a bond issued by a state, city or other local government. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, school districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. Interest income received by holders of municipal bonds is often exempt from federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an up front investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself.

Repayment schedules differ with the type of bond issued. Municipal bonds typically pay interest semi-annually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.

A great place to quickly check and compare rates and yields is Bloomberg.

The advantage of Tax Free Municipal Bonds is that they support the community and help reduce taxes for investors.

Below is a table showing the after tax equivalent for Tax Free Municipal Bond by interest rate at various marginal tax rates. To use the chart, simply select your marginal tax rate and then move across the row to find the after tax equivalent for the Muni Bond rate listed at the top of each column.

Example: Bobby Boomer has a marginal tax rate of 31% and purchases a Tax Free Muni Bond yielding 5.0%. This investment will pay him the same amount he would receive from another choice (without the tax free feature) yielding 7.2%. The effective yield is higher on Tax Free Municipal Bonds because no taxes will be paid.

The After Tax Equivalent of Tax Free Muni Bonds
Marginal Tax Rates
TFY of 3.5%
TFY of 4.0%
TFY of 4.5%
TFY of 5.0%
TFY of 5.5%
TFY of 6.0%
28% Tax Rate
4.9%
4.6%
6.3%
6.9%
7.6%
8.3%
31% Tax Rate
5.1%
5.8%
6.5%
7.2%
8.0%
8.7%
36% Tax Rate
5.5%
6.3%
7.0%
7.8%
8.6%
9.4%

Because Tax Free Munis pay an interest rate higher than T-Notes and T-Bills, we know they have greater risk. While unusual, it is possible for the issuer to go broke and declare bankruptcy. To mitigate this risk, many investors love municipal bond funds. Municipal bond funds reduce risk by pooling together a portfolio of muni bonds.

These funds have attractive yields, which is why Wall Street is cranking out new issues.

Closed-End Municipal Bond Funds

Closed-end funds are different than normal, "open-end" mutual funds, because they issue a set number of shares that trade on the stock exchange like any stock. However, the current stock price often doesn't reflect the value of their holdings - it may actually sell for a premium or discount .

Exactly why they trade at a discount is a principle of some debate. Some believe it happens simply because Wall Street overlook them. Another cause is that since most closed-end funds won't liquidate or ever convert to an open-end fund, so it makes no sense that their share prices would reflect that happening.

Clearly, it's usually better to buy funds at a discount because if you overpay, you're often get lower returns over time. However, you need to have a reason to make the investment in the first place. Don't put money into closed-end funds, just because you find a big discount. Determine if the investment fits you're own portfolio. For many investors they are a wonderful tool, but that doesn't necessarily make them right for you.

Closed-End Municipal Bond funds pay relatively high yields without any taxes and are fairly secure. So what is there not to like? A couple of things to consider.

New funds, the ones your broker likes, are usually overpriced. While your broker may tell you there is no commission on the purchase, munis have a hidden premium built into them - its the difference between what the broker buys the bond for and what the price at which they sell it to you. The result is you are paying may $15.00 per share to receive $14.35 worth of assets.

It's usually better to purchase muni bond funds used and avoid the new issues. Doing so, you can actually purchase many good funds at a discount! Imagine being able to purchase $15 dollars worth of assets for $13.20. If the bond fund should ever liquidate, you'd realize an immediate gain!

While admittedly the current rates aren't spectacular, they are a real alternative that can increase returns. Like all investments, they're not right for everyone. Do your homework, talk to your tax and financial professionals and enjoy your life. Remember, every day is precious. Call someone today and tell them you love them.

 

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