Where Do Leveraged Municipal Bond Funds Borrow Money From

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Munis, Magnified: Understanding The Trade-Offs Of Using Leveraged Closed-End Funds

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Municipal bonds are a traditional go-to for retirement investors, offering the potential for reliable income plus (in many cases) significant tax savings as well. Yet, muni bonds are hard for individual investors to access directly or efficiently, which is why most people invest in municipal bond funds instead. But not everyone is aware that they can choose between two different kinds of muni funds: open-end funds (traditional mutual funds) and closed-end funds. Both types of funds offer easy diversification and access to professional management. However, closed-end funds offer several unique features—including the ability to use leverage. For muni investors, leverage may be a tool that's worth learning more about.

Municipal bonds are a traditional go-to for retirement investors, offering the potential for reliable income plus (in many cases) significant tax savings as well.

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Why income investors still love municipal bonds

It's easy to see why municipal bonds remain a favorite for income investors. Many muni bonds offer income that's free of state, federal or AMT taxes—letting investors keep more of what they earn. What's more, compared to other asset classes, they may produce relatively high risk-adjusted returns with relatively low volatility. In fact, over a 20-year period, a hypothetical portfolio made up of 60% stocks and 40% municipal bonds would have returned higher after-tax performance than a 100% stock portfolio—with less risk

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Unfortunately, investing in individual muni bonds can be challenging. With literally tens of thousands of issuers, the bonds are difficult to keep track of and research. Credit quality varies tremendously, and so does yield. Municipal bonds are also fairly illiquid; they aren't sold on exchanges and must be purchased from a broker. And they are often too expensive for the average investors to be able to afford enough to bundle together in a well-diversified portfolio.

Closed-end funds can be an attractive alternative when investing in muni bonds. Closed-end funds:

Offer instant diversification with a single investment
Are usually actively managed, which enables them to tap into the expertise of professionals in sorting out credit quality and exploiting market and pricing inefficiencies
Are traded on exchanges, like stocks, so portfolio managers don't need to deal with constant inflows and outflows of cash from shareholders buying and redeeming shares
Have a fairly stable pool of assets, making it easier for them to invest in less-liquid assets like municipal bonds.

How leverage can help—and why it's important to understand the risks

For muni investors, the most interesting aspect of a closed-end fund may be its ability to use leverage. Leverage simply means borrowing money to invest in more securities. As long as the short-term rates that the fund pays to borrow are lower than the long-term rates that the fund earns on its investments, leverage can enhance returns. That can be a compelling advantage, especially for retirement investors who want to earn high, predictable income streams.

Leverage can be a compelling advantage, especially for retirement investors who want to earn high, predictable income streams.

There are some tradeoffs to consider. Leverage tends to magnify fund performance in both directions, producing higher highs but also lower lows. Swings in the fund's share price are likely to be wider. Income may be higher than it would be otherwise, but it can also be cut if short-term rate hikes make borrowing too expensive.Time, however, is also important — over a longer period, such as three or five years, leverage has historically delivered incremental income that more than compensated for the associated cost and added volatility. The following graph demonstrates this concept, using hypothetical returns and leverage costs based on municipal bond market indexes.

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Today, investors are eager to explore new avenues for diversifying their portfolios and finding better ways to enhance their income. Municipal bonds have weathered many storms and closed-end funds have been used for many years to pursue high, steady income for retirees. Munis and leveraged closed-end funds seem like a logical combination, and deserve a closer look by income-minded investors.

RISKS AND DISCLOSURES

It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund's investment objective will be achieved. Closed-end fund shares may frequently trade at a discount or premium to their net asset value (NAV).

Closed-end fund historical distribution sources include net investment income, realized gains, and return of capital. Leverage increases return volatility and magnifies a fund's potential return whether that return is positive or negative. There is no guarantee a fund's leveraging strategy will be successful. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time.

The material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or investment strategy and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors.

Nuveen Securities, LLC., member FINRA and SIPC.

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