Currently, the average municipal bond fund yields around 4 percent. If you want to stretch for higher yields, consider leveraged closed-end municipal bond funds, which pay tax-exempt yields as high as 7 percent. More than 250 leveraged closed-end muni funds now pay such high tax-exempt yields.
Closed-end funds do not redeem their shares daily, as mutual funds do. Most closed-end funds trade on a stock exchange or over-the-counter. Closed-end funds, moreover, frequently do what mutual funds almost never do: use leverage to boost current yields.
Say a closed-end fund raises $100 million from investors, which it invests in municipal bonds yielding 5 percent. That fund might sell $50 million worth of floating-rate preferred shares to institutions and high net-worth individuals. If the funds pays 1 percent to holders of its floating-rate preferred shares, it can invest that $50 million in long-term munis paying 5 percent.
This is a 4 percent spread, generating profits of $2 million a year (4 percent of $50 million). That $2 million can be distributed to the common shareholders, increasing their current yield.
However, if interest rates rise on the floating-rate preferred shares, the spread will narrow and dividends will fall. Thus, leveraged funds have risks as well as tempting yields.
