The Tax-Free CEF Marketplace

Safely producing multiples of income

by Steve Selengut

Mr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at [email protected]

How could anyone not be interested in Tax Free Yields of roughly 7%? On programs that have been in operation for nearly 20 years? And which are generally paying more now (after five years of historically low interest rates) than they did prior to the “financial crisis”?

As far as I can tell, managed Closed End Municipal Bond Funds have been around for roughly 25 years. Over 200 are covered in strenuous detail at cefconnect.com, a free website operated by Nuveen. You can study every detail of every fund as thoroughly as you choose to.

The basic principles are relatively simple. An investment company is established, a fund manager hired, and investment capital raised to fund the creation of a diversified portfolio of municipal securities. The fund’s capital structure will include short term borrowing equal to roughly 35% of the investment portfolio’s value. The common stock of the investment company is traded on the New York Stock Exchange (and, possibly, other exchanges).

The borrowing is referred to as “leverage”, which has an unfortunately distasteful connotation — as an evil conspiracy, of some kind, which adds “unsuitable” risk to the investment portfolio. It does no such thing, although it may lead to higher volatility, at or around times of general financial stress or when a change in the direction of interest rates is anticipated.

Don’t hate me because I’m easy

What many financial professionals hate about income CEFs is the ease with which they safely produce multiples of the income produced by high “mark up” individual issues and high commission mutual funds — this is not difficult to understand.

“Volatility” is another button-term (it means that the prices of investment securities go up and down — not just up as Wall Street would like y’all to expect) that the media likes to push to excite your fear, or to explain the force of gravity in the markets. Securities and markets, by their very nature, are volatile.

They have become more volatile in recent years because of those AOSVs I mentioned in my recent “Lemmings over the Cliff” article. Artificial Ownership Speculation Vehicles, you call them Index Sector Funds or ETFs, mirror security prices, but they are purchased for reasons that have nothing to do with the fundamentals of the companies involved — they multiply the movements, and other market bodily functions.

Back to CEF “leverage”. All commercial enterprise requires some leverage (i.e. borrowing); the vast majority of individuals (especially home owners) have far more “leverage” in their personal balance sheets than any of the CEFs in this study (yes, that was pure conjecture, but it does drive home the point fairly well).

Acceptable margin collateral

The borrowing is referred to as "leverage", which has an unfortunately distasteful connotation --- as an evil conspiracy, of some kind, which adds "unsuitable" risk to the investment portfolio. It does no such thing

And unlike personal borrowing or security margin programs, there is no direct “collateral” relationship between the CEF manager’s short-term borrowing and the managed portfolio. In fact, CEFs are themselves, acceptable margin collateral — even the margin gods find them less speculative than some financial professionals want you to believe. But “triple the daily change in the S & P short” ETFs…. yeah, baby!

Wheels turning? Yes (after you have checked with an accounting professional), if you own a portfolio of tax free CEFs, you can actually use it as an emergency borrowing fund! Think about it, but not if you are one of my clients — margin loans are not acceptable for individuals except in dire emergencies. If you have a “C” corporation, this can create a little financial magic for you. Call me if you don’t understand.

Unlike ordinary Mutual Funds, a fixed number of shares are issued and traded just like any other company’s shares. The share owners receive dividends, generally on a monthly basis, equal to the excess of interest received by the fund over the fund’s expenses. The fund stock price is a function of supply and demand for the common stock of the investment company; nothing at all to do with the net asset value of the portfolio itself.

Baffling simplicity

Wall Street seems baffled by this simplicity. It insists upon focusing on useless NAV vs. stock price comparisons and refuses to include these clearly “income purpose” securities in the “income” asset allocation bucket of monthly statement pie charts.

Surprisingly, there are slightly more state specific funds than there are better diversified “national” funds. Clearly more speculative from a diversification standpoint in less than mega portfolios, personal accountants myopic focus on tax benefits can get you into diversification trouble. There are 28 separate California bond only CEFs… go figure.

The distribution rate for the Muni CEFs funds ranged from 3.54% to 8.17%; more than half had yields between 6% and 7%; 130 were selling at a discount to net asset value. Based on a 15% sampling, the funds are just under 20 years old, contain nearly 260 individual issues, and have an average distribution rate of 6.86%. The annual bond turnover rate is roughly 20%, and most important of all: they are just volatile enough to allow for productive trading.

Income investing becomes simple with CEFs. The income is the same regardless of the market value. When the price goes up, they can be sold in a liquid market. When prices fall, positions can be added to, increasing yield, reducing cost basis, and making the next profit taking moment draw closer on the horizon.

Nothing (almost) has concerned me more throughout my career, than the fact that there are still investors out there:

  • sitting on millions of dollars of very low percentage, taxable Government securities and CDs;
  • with multi-million dollar portfolios containing high percentage positions in California bonds, and other ultra short term, lowest of yields, “churnables”
  • who lament over lower CEF market prices when they are fully capable of taking advantage of the higher yields;
  • who would sell their income safety net to jump into bubbling stock markets at five year market highs.

The fact that they exist is understandable; the fact that I have been unable to educate them is unacceptable.