The recent surge in interest rates has pressured municipal bond prices, with the sector posting its worst quarterly return since 1981, according to Nuveen. The decline was driven primarily by a sharp spike in rates rather than credit deterioration. Despite price losses, income generation has become particularly attractive: by early October, the yield on the Bloomberg Municipal Bond Index had reached 4.78%. As yields rise and prices fall, the tax-free income on offer is compelling, especially for high-income investors. For instance, a municipal bond yielding 3.5% is roughly equivalent to a taxable yield of 5.45% for an investor in the 32% federal tax bracket subject to the 3.8% net investment income tax.
The current environment has heightened interest in closed-end funds (CEFs) that focus on municipal bonds. Unlike open-ended mutual funds or ETFs, CEFs have a fixed number of shares that trade on exchanges, often at a premium or discount to their net asset value. They also employ leverage, which can enhance long-term returns but adds volatility and can magnify losses. Expense ratios for actively managed CEFs frequently exceed 1%, and because distributions may include interest, capital gains, and return of capital, investors must carefully evaluate the source of income. Nuveen’s Quality Municipal Income Fund (NAD), for example, offers an 8.2% distribution rate and trades at a 3.64% discount to NAV, while BlackRock’s MuniHoldings Fund (MHD) provides a 6.79% distribution with a 9% discount. Nuveen’s Dan Close notes that for investors who can tolerate daily NAV and price volatility, these funds are efficient vehicles for delivering high levels of tax-exempt income. However, Tyler McConville, CFP at The Capital Group, warns that most retirees prioritize tax-efficient income and risk management, and the discount-to-NAV risk and leverage inherent in CEFs may not suit every objective.
Investors seeking a simpler approach may consider constructing a laddered portfolio of individual municipal bonds, purchasing bonds with varying maturities and reinvesting proceeds as they fall due. This strategy allows investors to match cash needs and hold to maturity, which many find reassuring, as noted by Eileen Olson, CFP of Emerald Wealth. The primary constraint is capital requirements; Olson estimates a minimum of $250,000 to build a diversified muni portfolio. For those with more modest savings, exchange-traded funds provide instant diversification. Vanguard’s actively managed Core Tax-Exempt Bond ETF (VCRM) offers a 30-day SEC yield of 4.49% with an average duration of 7.5 years, while the largest passive muni ETFs include the Vanguard Tax-Exempt Bond ETF (VTEB) and iShares National Muni Bond ETF (MUB). Vanguard’s Matthew Wrzesniewsky notes that the intermediate part of the muni yield curve presents attractive opportunities, and that window of opportunity remains open.