Q. How about municipal bond funds rather than individual bonds? Do they make sense? I have money in a closed-end muni fund (MAV) that’s paying over 7 percent. The interest income comes in at the end of the month, every month. I know that can’t go on forever and I would imagine when interest rates go up I will need to make an adjustment. But 7 percent and no tax ain’t bad! That works for my math. — R.H., by email
A. Seven percent is an inspiring yield, but you should also be considering how much risk you are taking to get that yield. Here are three major risks that you may not have put into your income equation:
- Interest-rate risk (a). If your fund holds long-term bonds and interest rates rise, how much will the value of your fund decline?
- Interest rate risk (b). If your fund uses debt leverage to boost return, how will an increase in short-term interest rates affect the income and value of your fund?
- Credit risk. If your fund invests in lower quality municipal bonds and the economy slows, the value of these bonds could fall.
To get a 7 percent yield, it is very likely that all three forms of risk are present in this closed-end fund. If you visit the Closed-End Fund Center website (www.cefa.com), for instance, and drill down to high-yield municipal closed-end funds, you will find funds with distribution yields around 7 percent. What you will also find, however, is that these funds often sell for a premium over net-asset value while most closed-end funds, historically, tend to sell at modest discounts to net-asset value.
Here is what will happen if interest rates rise. First, the value of the bonds held will decline. Worse, since a portion of the portfolio was purchased with borrowed money, the loss will be magnified. Second, the interest cost of the borrowed money will likely rise, reducing the net distributable income from the fund, a good reason for the premium to disappear. If something like this happens it would not be the first time.
Q. I am really confused right now and have many questions about what is the best thing to do with our investments. Presently we are invested in what you would call a portfolio. One of the reasons my CFP gives for investing in certain funds is that they perform well in different markets when the Dow and Nasdaq may be down, allowing the portfolio to at least make some money that year.
My question, though, is what if you don't care about a down year or two? What if you are more concerned about the long-term end result? It is difficult to have conversations like this with my CFP. Maybe it is a question of a neophyte. However, I see individual funds and what they have done over 10 and 20 years, and my question is, why not invest in these tried and true funds and forget the rest? I have funds that in the current bull market are not doing anything, yet I am told, “Remember 1992, 1993 and 1994!!” — S.R. by email
A. I don’t know your financial planner, so I don’t know what his thinking is. But I can tell you what portfolio building CFPs try to do when they are putting a portfolio together—— they try to put together a combination of asset classes, each represented by a mutual fund, that will work to “smooth your ride.” If you simply look for the best, top-performing funds you may achieve your goal (in some years) but give it all back in others.
Suppose, for example, your portfolio had a fund that doubled in a year, making a $100,000 investment grow to $200,000. But in the next year the same fund lost half its value, taking your portfolio back down to $100,000. The “average” return was 25 percent (100 percent gain less 50 percent loss divided by 2), but your actual return was zero.
Now imagine a less volatile portfolio where some of the moves cancel out the others. It rises 20 percent in a good year, but declines 10 percent the next. So your $100,000 rises to $120,000 and then falls to $108,000. The net result is that your more stable portfolio, with lower returns, ends the period with, yes, an actual return. More money.