Bond Rout Continues: Leveraged Municipal Funds Face Losses

Interest rates are rising, slashing muni fund share prices and cutting the amount of income distributed to investors.

The worst bond sell-off in decades has now sparked double-digit losses for leveraged municipal bonds funds. With yields at an all-time low over the last decade, high-net-worth individuals seeking tax-free income turned to closed-end muni mutual funds instead. This, however, has also been affected by the sell-off. 

What is a Closed-end Muni Fund? 

A closed-end muni fund, like a public company, issues shares that investors can trade among themselves. However, unlike the more common open-end mutual fund, investors cannot add money to closed-end funds or redeem shares for cash. Closed-end muni mutual funds are worth a total of approximately $60 billion. Closed-end funds are typically defined by leverage – borrowing and investing an amount equal to about one-third of their value. This strategy can boost returns while amplifying losses. 

What is the Current Landscape for Closed-end Muni Funds? 

Closed-end muni funds returned minus 15.9 percent in the first five months of 2022, after accounting for share price changes and assuming distributions were reinvested. This compares to a total return of -7.47 percent for the Bloomberg muni bond index.

Those losses reflect drastic changes in fixed-income markets that have upended decade-old investing strategies in the aftermath of the Federal Reserve’s aggressive campaign to curb inflation through interest-rate increases.

Short-term interest rates have risen, limiting the amount of income that closed-end funds can pay out to investors after deducting borrowing costs. Meanwhile, falling bond prices have reduced the market value of mutual funds because the availability of newer, higher-yielding debt makes lower-yielding options less appealing.

With investors selling bonds across the market, there are fewer eager buyers for the closed-end fund shares that frightened households are selling. These investors cannot redeem their shares, meaning they can only sell them for the price that a buyer will pay. 

The share price of closed-end muni funds was an average of 93 percent of the underlying bond value last month. Dave Lamb, Head of Closed-end Funds at Nuveen LLC, stated that the Nuveen Quality Muni Income Fund was trading at $11.78 per share last month, while the underlying bonds were valued at $12.90.

This has an impact on investor behavior. Now more than ever, individual investors “look at their statements and say, ‘I’ve had it, I’m down 20%, and I want out,'” according to Sangeeta Marfatia, Senior Closed-end Fund Strategist at UBS. However, analysts and fund managers across the board state that closed-end funds have proven appealing to investors who have held their shares through periods of negative returns, such as the 2008-09 financial crisis and a string of losses in 2013. Indeed, closed-end muni bond funds had an average annualized return of 5.8 percent over the decade ended Dec. 31, after accounting for price changes and assuming income reinvestment.

“We’re not really designing it for people trading the funds,” Mr. Lamb explained. “They’re designed to provide attractive levels of income.” The Nuveen Quality Muni Income Fund – a leveraged closed-end fund that invests in investment-grade bonds, had an annualized return of 4.18 percent for the decade ended May 31, including share price changes and distributions, compared to 6.73 percent for the decade ended Dec. 31. A comparable unleveraged closed-end Nuveen muni bond fund returned 3.09 percent in the May decade and 4.68 percent in the December decade.

According to Nuveen data, a 3.5 percent tax-free return is equivalent to a taxable rate of 5.15 percent for an investor with $200,000 in taxable income. Some more recent closed-end fund investments have lost money. According to Nuveen, an investor who put $10,000 in the closed-end Nuveen Dynamic Municipal Opportunities Fund when it was established in August 2020 would have $9,552 today if all income was reinvested. Mr. Lamb stated that the fund “has run into pretty significant headwinds in its roughly 212-year life.”

Closed-end Muni Fund Investors 

According to the Investment Company Institute’s 2020 data, approximately four million US households invest in closed-end funds. Almost half of all closed-end fund investors are retired. They’re 54 years old on average, have a median household income of $135,000, and a median net worth of $500,000.

Such investors are drawn to the $4 trillion municipal bond market because interest on bonds issued by state and local governments is typically tax-free at the federal and state levels. Under federal policies aimed at encouraging public infrastructure projects such as high schools, sewer systems, and toll roads, states, cities, and school districts can borrow at tax-free rates.

However, in recent years, extremely low-interest rates have dampened returns. The practice of investing additional borrowed money multiplied gains, so leveraged closed-end funds provided a way to earn more tax-free income. It is now increasing losses.

The Future for Muni Bonds

Open-end municipal bond funds are suffering as much as close-end bonds. Investors have pulled more than $80 billion from municipal mutual and exchange-traded funds this year, more than in any full calendar year since 1992, according to Refinitiv Lipper data. This outlook demonstrates a broad set of losses across the muni bond landscape, that investors would be wise to consider in their future investments moving forward.

Perform an in-depth search of the complete holdings of all municipal bond funds with the Municipal Bond Funds Liquidity Screener.