Tues 1/24/12 2:11 PM – 7% Tax Free Dividends on Muni Closed End Funds

What’t the best place to invest for income with rates so low? One good place is closed end funds investing in municipal bonds. I like several, NZF for example.

What they do is to buy long term municipal bonds paying, say 5% federally tax free interest and then borrow 40-50% more at 0.25% and invest that at 5%. The end result after expenses is a 7% federally tax free monthly dividend on A-AAA rated bonds.

What could go wrong? Well, there could be some scare in the muni market as was the case a year ago when Meredith Whitney, an analyst with a big following back then predicted a wave of defaults in munis. It did not happen but these funds lost 20% in a month and since then have gained it all back. Interest rates in general could go up (unlikely in the near term) or Congress could rescind the tax free status of muni bonds (very unlikely). Or, being sold on the stock exchange they could get caught in a big general market selloff a la 2008. Over the last year they have not dropped when stocks dropped but that could always change.

Any of these risks would give some warning. Remember that the market downturn in 2008 took months to unfold. Since these can be sold any business day one could sell out whenever one is uncomfortable. Keep in mind, not too many shares of these trade every day (NZF has an average daily volume of 70,000 shares) so very large positions like 100,000 shares could take a few days to unload.

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