The global investment management company BlackRock says that a sharp sell-off at the beginning of 2022 pushed down the value of municipal bonds and municipal closed-end funds. But now, lower valuations and higher yields could create an opportunity for investors to earn more tax-exempt income. Here’s what you need to know.
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Why BlackRock Wants You to Seize This Opportunity
BlackRock says that both municipal bonds and municipal closed-end funds faced a severe correction in the first four out of five months in 2022. But now, the global investment company believes that after one of the worst drawdowns in history, “higher absolute yields and attractive valuations may provide a favorable entry point for investors seeking tax-exempt income.”
Specifically, BlackRock recommends investing in municipal closed-end funds that buy tax-free municipal bonds.
Closed-end funds can pay investors dividends on a monthly, quarterly or annual basis. And while the IRS generally considers this money taxable income, municipal bonds are tax-exempt.
When you buy a municipal bond, essentially you are lending money to the government that issues the bond in exchange for interest payments. This money is tax-free at the federal level and can also be tax-free at state and city levels. However, investors could face an alternative minimum tax when their income reaches a certain limit.
Closed-end funds managers typically leverage fund assets (see fuller explanation in the section below) to borrow on short-term interests and then use the extra cash to buy more assets. Managers can also make money by purchasing fund shares at a discount to net asset value, which is the current value of investments owned by the fund. This is calculated by deducting the liabilities of a fund or company asset from its total value.
BlackRock says that surging inflation and expectations of an interest rate hike by the U.S. Federal Reserve—which rose 0.75% on June 16, the highest increase since 1994 (28 years)—drove municipal bond prices down by a -6.7% return on the S&P Municipal Bond Index (year-to-date through May 2022).
But, when compared with other fixed-income asset classes, the global investment company says that recent volatility has made lower municipal valuations a better deal for investors.
Should You Invest in Municipal Closed-End Funds Now?
Both open-end funds and closed-end funds are professionally managed. This means that fund managers will be responsible for choosing fund investments. But whereas open-end funds have no limit on the number of shares issued, closed-end funds have a fixed number of shares to trade.
And this structural difference, Black Rock says, could give closed-end fund investors an advantage in the current market.
The value of closed-end funds can go up and down depending on supply and demand. And because of the sharp sell-off at the beginning of 2022, investors can buy them at a discount to net asset value now and earn more money when prices go back up later.
Additionally, closed-end fund managers could use leverage to boost returns. Investors use this financial strategy to increase their buying power in the market. And companies use it to pay for assets.
In the case of closed-end funds, BlackRock says portfolio managers can use leverage to borrow money at short-term interest rates and then invest proceeds in tax-free municipal bonds that pay higher yields. And this investment, when compared with municipal bonds and mutual funds, could increase the closed-end fund’s earnings and pay out higher income distributions.
For reference, the global investment company says that municipal closed-end funds offered a median tax equivalent yield of 8.9% at the end of May 2022, which is more than twice the yield of municipal mutual funds (4.1%) and over 4% higher than municipal bonds (4.7%) during that same period.
One thing to note: BlackRock says that investors need to keep an eye on the shape of the yield curve. A narrower spread or flatter yield curve between the short-term interest rates that money is borrowed on and the longer municipal bond maturities where money is invested could have a negative impact on your earnings.
Another factor to keep in mind: Borrowing costs could increase when the U.S. Federal Reserve raises short-term rates. And this will also eat into your profits when these rates go up again.
Investors generally consider the municipal bond market to be stable. But inflation and recent interest rate increases have driven bond performance to one of the worst drawdowns in history. Now, BlackRock says that lower valuations and higher yields have made municipal closed-end funds an attractive investment. Portfolio managers can leverage the fund’s assets to borrow on short-term interests and then use the extra cash to buy more tax-free municipal bonds. But investors should note that this strategy is only sustainable when the fund’s holdings yield more than what is borrowed.
- If you want to find new investment opportunities for your portfolio, a financial advisor can help you figure out the best options. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When investments pay off, you will need to figure out how much you owe in taxes. SmartAsset’s capital gains tax calculator will help you estimate how you will be taxed in your location.
- If you don’t have a lot of money to invest, you might also consider a robo-advisor online, which offers lower fees and account minimums than traditional financial advisors.
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