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Municipal bonds aren't usually thought of as exciting investments. But buy them through a closed-end fund and you can get tax-free yields of 6% or better. For a taxpayer in the highest tax bracket, that's equivalent to a nearly 10% after-tax return -- a lot better than most of us have been doing in the stock market lately.
A closed-end fund is kind of a cross between a regular mutual fund and a stock. Like a regular mutual fund, each closed-end fund owns many securities, eliminating much of your credit risk.
Keep an eye on income
Like a stock, a closed-end fund typically issues shares only once, when it first goes public. After that, the shares trade based on supply and demand on a stock exchange -- often at a premium or discount to the value of the fund's holdings.
When closed-end muni funds are in favor, they often trade at small discounts or even premiums to the value of their bonds. When they go out of favor, they often trade a steep discounts. Currently, discounts are relatively wide.
For long-term investors, after you buy a fund the size of the discount or premium doesn't matter that much. What does matter is the regular tax-free income. If you buy one of these funds, don't abandon ship when it falls to a steep discount. Remember, these funds offer a bumpy, but ultimately rewarding ride.
Supercharging returns
About 90% of the 228 municipal closed-end funds add another wrinkle designed to supercharge returns. They use leverage. In other words, they borrow money at short-term interest rates and invest it in long-term bonds.
Investing that borrowed money is what enables municipal closed-end funds to pay out those fat 6% yields -- roughly two percentage points more than you can get from an ordinary municipal bond or bond fund.
So long as long-term yields stay higher than short-term yields, using leverage pays offs. But when short-term yields rise, these funds get clobbered.
In 1999, for instance, the average closed-end fund fell 5.8% based on the value of its bonds. What's worse, investors panicked and sold the funds en masse. That meant the average such fund's market value plunged 17.6%.
But patient investors have since profited handsomely. The average closed-end fund's market value rose 16.6% last year, and the average fund is posting double-digit returns again this year.
Most exciting funds
Mariana Bush, who tracks closed-end funds for First Union Securities, recommends Nuveen Performance Plus Municipal Fund (NQS).
Like most municipal closed-end funds, these three usually buy new bonds only when older ones are "called" or redeemed by their issuers. Bush likes them because of their relatively high yields (all over 6%) and because most of their bonds aren't subject to call anytime soon, which means their tax-free dividends are stable.



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