EnvisionCap.com: Forbes Article - How to buy Closed-Ends

How to buy Closed-Ends

Marilyn Cohen, Forbes Magazine, 03.12.07

You're in a high tax bracket and you are looking for yield. What investments are suitable? Two obvious choices, one or both of them no doubt already in the portfolio of most FORBES readers, are municipal bonds owned directly and muni bonds owned through an open-end fund like the Fidelity Municipal Income Fund. Here's a third option I'd like you to consider: muni bonds owned through a closed-end fund. Consider it, but consider carefully. Closed-end muni funds have some advantages. They also have some disadvantages you should understand before putting in your buy order.

A closed-end fund has a fixed number of shares outstanding. The sponsor is under no obligation to redeem shares. So, when you want out, you have to find someone else willing to take the shares off your hands. The shares in the fund, that is, trade like shares of General Motors (nyse: GM - news - people ) stock and, depending on supply and demand, can trade at a premium or discount to the value of the portfolio. Usually they trade at a modest discount.

Because the portfolio manager of a closed-end does not have to worry about redemptions, he can put 100% of the assets to work in long-term bonds. Indeed, closed-ends often invest more than 100%. They might buy $1.50 of long bonds for every dollar that fund shareholders have put in, borrowing the 50 cents in the form of floating-rate notes that pay tax-exempt interest. If short-term interest rates are lower than long-term rates, this leverage gooses the fund's yield.

At the moment AA-grade munis due in 20 years yield 4.3%, while the short-term paper issued by closed-end muni funds yields 3.5%. The modest spread between these two numbers enhances the dividend payable to the fund's shareholders. The leverage also enhances the portfolio's market fluctuation. If muni bond prices go up, the holder of a leveraged muni fund will do better than someone who just buys munis.

But remember that leverage cuts both ways. When interest rates rise and bond prices fall, the leveraged muni fund will suffer an exaggerated decline in its net asset value. Buy a leveraged closed-end bond fund if, and only if, you are confident that interest rates are going to go sideways or down.

What about that discount? Neuberger Berman California Intermediate Municipal Fund (amex: NBW - news - people ) (14, NBW ), for example, sells at a 3.6% discount to its net asset value. Does that enhance your return? Yes, but not as much as you might think. If you are lucky enough to buy a closed-end when it's trading at a 10% discount and then sell when it's trading at a 5% discount, you will get an extra return above and beyond the return on the fund's portfolio. But it is usually unwise to count on a narrowing of the discount; the discount could just as easily widen, depressing your return. Caution: Nowadays muni fund discounts are already narrow.

The BlackRock New York Municipal 2018 Term Trust (nyse: BLH - news - people ) (16, BLH ) trades at a 2.7% discount to net asset value. That's one you can count on to disappear. The fund will liquidate at full net asset value in 12 years. But don't get too excited about this benefit. It comes to all of 0.23% (23 basis points) per year.

Buying at a discount helps you in another way. It raises your yield. If a fund portfolio yields 4% and you buy shares at a 3% discount, you get a 4.12% return on your money. Twelve basis points is better than nothing, but it shouldn't distract you from bigger matters, like ownership costs.

One big disadvantage of closed-ends: They tend to be expensive to own. First you have trading costs (commission plus bid/ask spreads), which might come to 1% round-trip for that Neuberger Berman fund. If you own it for a decade these costs will leave you with a return ten basis points a year below that of an open-end fund with an identical portfolio. Then there is the annual expense burden. For the Neuberger Berman California fund this damage comes to 0.93%, or 48 basis points more than the Fidelity California Municipal Income Fund's expenses. The BlackRock (nyse: BLK - news - people ) 2018 fund costs 1.03% a year.

Now let's address one final point about tax-exempt bond funds, one that might, depending on your circumstances and on the fund you're considering, tilt the balance in favor of a closed-end. That is the alternative minimum tax. If you pay AMT, as many middle- and upper-class investors do, then interest from some munis becomes taxable, and you want to avoid funds that hold too many of these bonds. The Neuberger Berman California closed-end has 14% of its portfolio subject to the AMT. The Vanguard California Long-Term Tax Exempt Fund: only 2%.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.