3 Municipal Bond Funds for Rich, Tax-Friendly Yields

Western Asset Intermediate Muni Fund

• Assets under management: $121.0 million
• Distribution rate: 3.3%
• Expenses: 1.76%

Let's start with the Western Asset Intermediate Muni Fund (SBI, $8.59), which trades at an unusually large 14.1% discount to NAV right now. The fund's average discount over the past five years has hovered around the 8% level.

That high discount also makes SBI's reasonable 3.3% distribution rate incredibly sustainable. That's because SBI really only needs to yield a roughly 2.9% yield from its investments to afford its current payout. In fact, given that the average coupon of SBI's portfolio is 4.9%, it's entirely plausible that SBI could increase payouts in the future, which in turn would bring in more buyers.

But even if that doesn't happen, you're still getting a tax-equivalent yield of 5.2%, which is nothing to sneeze at.

As for the portfolio itself, Western Asset Intermediate Muni typically invests at least 80% of its assets in investment-grade municipal bonds with maturities of between three and 10 years. Right now, SBI's 211-bond portfolio is of very high quality, with 92% of the portfolio at an investment-grade BBB or higher. Holdings include municipal bonds tethered to things such as transportation, industrial revenue, power, and water and sewer.

Like many closed-end funds, SBI uses debt leverage in an attempt to enhance returns; at the moment, it has a 25% leverage ratio, according to Morningstar. That means for every dollar of investible capital it has, 25 cents of that comes from debt leverage.

As you'll see in a moment, you can certainly get better yields out of municipal bond CEFs. But if you want a pretty reliable payout that's better than the 1.3% on offer from an index fund such as the iShares National Muni Bond ETF (MUB), SBI is worth checking out. Just note that because of leverage, its price often will be more volatile than the likes of MUB.

Learn more about SBI at the Legg Mason provider site.

Pioneer Municipal High Income Advantage Trust

• Assets under management: $252.4 million
• Distribution rate: 4.8%
• Expenses: 2.61%

If you're looking for more yield than SBI, you can consider the Pioneer Municipal High Income Advantage Trust (MAV, $10.56) – another broad-based municipal bond fund whose 4.8% yield can be chalked up to a number of factors.

One is fairly high leverage of 36% at the moment. Another is a somewhat lower-quality portfolio of bonds; 70% are investment-grade, and only about two-thirds are rated A or higher.

That might sound alarm bells for risk-averse investors. But understand that, based on Moody's data from 1970 to 2008, muni bonds have a very low default rate of less than 0.1%. Moreover, the Federal Reserve is lending a hand by buying up municipal bonds. Spreading out assets across roughly 150 holdings helps tamp down risk somewhat, too.

Another factor helping out the yield – and reducing risk for new money – is a deep 12.5% discount to NAV that's four times its five-year average.

None of this means you can completely escape the potential risk of greater muni-bond defaults should the economy's turnaround take much longer than hoped for. But if you're really looking for minimal risk, you're better off avoiding munis altogether and seeking out Treasuries or money-market funds.

Learn more about MAV at the Amundi Pioneer provider site.

Nuveen New Jersey Quality Municipal Income Fund

• Assets under management: $551.2 million
• Distribution rate: 5.0%
• Expenses: 2.07%

Finally, the Nuveen New Jersey Quality Municipal Income Fund (NXJ, $13.28) is a great example of a fund's income benefitting from a massive discount to NAV. Specifically, its roughly 5% yield is propped up by a nearly 17% discount. That makes it one of the most heavily mispriced municipal bond funds on the market.

Part of the reason behind NXJ's big discount is its focus on a single state: New Jersey. This lowers the appeal of many bond investors in other states who feel uncomfortable with or alienated by a bond from another part of the country. Moreover, unless you're a New Jersey resident, you don't get the additional state tax break on NXJ's income.

But investors nationwide should still consider taking advantage of this market inefficiency.

The vast majority (94%) of the portfolio is rated investment-grade. In fact, 18% of NXJ's holdings have an AAA rating – the highest grade Standard & Poor's doles out. And New Jersey has had fewer defaults than the market average of less than 0.1%, so the risks in Nuveen New Jersey Quality Municipal Income don't appear significantly higher than in other muni bond funds.

That makes NXJ's yield all the more compelling.

Learn more about NXJ at the Nuveen provider site.

For more great income ideas check out Michael's latest free special report, "Indestructible Income: 5 Bargain Funds with Safe 8.7% Dividends."