For years, my closest interaction with bonds was watching the movies starring Sean Connery, Roger Moore, Timothy Dalton, Pierce Brosnan, and Daniel Craig. But those aren't the kinds of bonds I'm interested in these days.
I now own series I savings bonds and a fund that invests in a wide range of corporate bonds. And I recently added another kind of bond to the mix. Here's why I just loaded up on municipal bond funds.
Attractive valuations
Over the last few weeks, I invested in three municipal bond funds managed by Nuveen:
| Municipal Bond Fund | Yield | Discount to NAV |
|---|---|---|
|
Nuveen AMT-Free Quality Municipal Income Fund (NEA +0.07%) | 3.75% | 12.97% |
| Nuveen Quality Municipal Income Fund (NAD 0.42%) | 3.98% | 13.58% |
| Nuveen Municipal Credit Income Fund (NZF +0.00%) | 4.5% | 13.98% |
Data source: CEF Connect.
You might wonder why I'd buy these municipal bond funds when short-term Treasury bills offer even higher yields. For example, the U.S. 3-Month Treasury and U.S. 4-Month Treasury yields currently top 5.2%.
One primary reason I invested in these municipal bond funds instead of U.S. Treasuries is because of their attractive valuations. All three of these Nuveen funds are available at steep discounts to the net asset values (NAVs).
It's not unusual for these funds to trade below their NAVs. However, the current discount is greater than usual, as shown in the chart below for the Nuveen Municipal Credit Income Fund.
Recession likely on the way
I think that the discount to NAV will narrow considerably in 2023 for all three of these municipal bond funds. Why? The likelihood of a U.S. recession is increasing.
It's not just economic indicators that are sounding the alarm about a potential recession -- although several of them are. The experts who are in the best position to anticipate what's next for the economy think that a recession is now more likely.
In the Federal Open Market Committee's March meeting, staff economists presented data that indicated the chances of a recession have risen as a result of the banking crisis. When the Fed thinks a recession could be on the way, it's wise to pay attention.
When the U.S. economy enters into a recession, investors typically flock to safe assets that pay attractive yields. Sure, Treasury bills will be a top destination for this money. However, municipal bonds should also enjoy a lot more love. Because these three Nuveen municipal bond funds use leverage to boost their total returns, they should especially benefit from a surge.
An added bonus
There's also another bonus associated with investing in municipal bonds: You don't have to pay federal taxes on the interest received. This means the equivalent taxable yield on municipal bonds is well above the stated yield, especially when you're in a federal tax bracket of 22%, 24%, or higher.
Keep in mind, though, that this tax exemption only applies to interest received and not to any capital gains. Still, the tax advantages played an important role in my decision to invest in municipal bond funds.
One key downside
There's one key downside to investing in any type of funds -- expense fees. I'm not thrilled that these three Nuveen funds all have expense ratios of well over 1%.
However, I expect that the total returns will more than offset the fees I have to pay to have experts manage a basket of municipal bonds. If I'm wrong, I'll go back to those other kinds of bonds -- the ones with a capital "B" that like their martinis shaken, not stirred.
