Everybody likes a bargain. One such bargain today lies in municipal bond closed-end funds. Although they are not as attractive as they have been at in other points in time, municipal bond closed-end funds currently have an average discount to net asset value of around six percent. This means that investors can purchase $1.00 worth of assets for $0.94, while collecting 4.3% tax-free income (Source: Bloomberg). While smart bargain hunters realize that value is always relative, the high quality assets generally underlying each municipal bond closed-end fund as well as solid credit fundamentals warrant a further look.
One of the little known secrets that investors should know is that municipal funds must amortize premium bonds within the fund, which allows investors in these funds an opportunity to realize a loss when they sell their shares. In contrast, if an investor were to purchase individual bonds at a premium, they would not have the ability to realize this valuable loss, as they would have to amortize bonds purchased at a premium over the life of the bond. What’s more, this amortization of a premium bond is not considered a loss for tax purposes and cannot be deducted.
Even though this sounds like a complicated topic, the bottom line is that buying a municipal fund instead of buying individual municipal bonds could prove more advantageous because of the ability to both harvest short-term losses and delay capital gains as circumstances warrant. If rates were to rise, this significant fund advantage could be further exacerbated because premium bonds can offer a higher income stream, a mitigation of reinvestment rate risk, and a lower duration.
Retail investors tend to purchase par bonds with the simple understanding that they will receive their coupon payments, and, if they hold it to maturity, they will receive their original principal. By steering clear of premium bonds, or bonds purchased at a price above par value, they think that somehow the premium is lost if they hold the bond until maturity. Although this logic may seem true, it is flawed.
Indeed, premium bond investors will be paid less for their bond at maturity. However, because premium bonds offer a higher coupon, the payment of the higher rate compensates investors for the premium they are paying and the longer the premium bond is held, the more the higher coupon impacts the investment’s total return. Professional bond managers often prefer premium bonds as these bonds are often undervalued and provide better returns.
The higher coupon payment also means that cash is returned to investors more quickly, which can mitigate reinvestment rate risk in a rising rate environment. More simply stated, when investors receive a higher coupon, they can reinvest the higher cash flows as rates increase. As another benefit of a higher coupon, premium bonds also tend to have a lower duration, or sensitivity to interest rate changes. This means that even though their price will decline if rates rise, it would only do so at a decreased rate (in comparison to lower coupon bonds having the same maturity).
All factors combined, premium bonds can prove to be an attractive investment option for investors. When premium bonds are purchased at a discount in the closed-end fund format, the advantages can become even more magnified with significant tax-free income and the ability to harvest gains and/or realize losses. Unlike mutual funds, closed-end fund managers also have the added benefit of not having to meet investor redemptions through security liquidations.
Purchasing a closed-end municipal bond fund that holds premium bonds might be a great way to help your portfolio reach its intended destination. To learn more about premium bonds and/or municipal closed-end funds, contact your financial professional for more information.