Q: In looking for good sources of investment income, I see that some closed-end municipal-bond funds are yielding as much as 7.5 percent, tax-free. The bond ratings of their underlying...

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Q:

In looking for good sources of investment income, I see that some closed-end municipal-bond funds are yielding as much as 7.5 percent, tax-free. The bond ratings of their underlying securities average “AA.” How can the yield be so high on these? Is there risk involved that I don’t understand?

I know part of the answer is they are selling several percentage points below net asset value. This may account for a half percentage point of the yield. What should I know?

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A:

At the end of October, the 294 closed-end, tax-free bond funds tracked by Morningstar sold at an average discount to net asset value of 3 percent.

While some sell at higher discounts, the real source of high fund yields is debt leverage. Many funds borrow short-term cash at rates below what they earn on their portfolio holdings. The result is higher net yield.

That’s the good news. When short-term interest rates rise, however, the income from leveraged tax-free funds will fall. This makes them far more risky than unleveraged funds.

In the current market, 30-year AAA-rated tax-free bonds are yielding only 4.65 percent. Higher yields mean you are taking higher credit risk, higher risk through debt leverage, or both. Trust me, if the yield is 7.5 percent, you’re taking lots of risk.


Mutual-fund costs


A new study shows that mutual-fund investors pay substantial expenses they don’t even know about. In some instances, these expenses are larger than the easily obtained “annual expense ratio” figure, so it is possible some of your fund choices cost twice as much as you think. No, this is not a call for Eliot Spitzer.

The central issue here isn’t moral turpitude. It is the long-term impact of expenses on fund performance. (Needless to say, better disclosure would help.)

The study, “Portfolio Transaction Costs at U.S. Equity Mutual Funds” by Jason Karceski and Miles Livingston at the University of Florida and Edward O’Neal at Wake Forest University, deals with a big gray area of mutual-fund costs: transaction costs.

Brokerage commissions can be objectively known but are not readily available. They are mentioned in some fund prospectuses, but not in others. To have regular access to brokerage expenses, you need to access a little-known SEC filing, the SAI (statement of additional information).

Even then, your knowledge will be incomplete because an important part of transaction costs can only be estimated. It is the bid-ask spread on any trade — the difference between the market maker’s bid and ask prices.

For mutual funds, whose transactions can affect market prices, this looms larger than direct brokerage commissions. The researchers found that brokerage commission costs averaged 38 basis points (0.38 percent) as a percentage of fund assets. This amount was smaller than the bid-ask spread cost, which averaged 58 basis points, or 0.58 percent of fund assets.

The 96 basis points total, or 0.96 percent, is higher than the expense ratios of many large mutual funds. Add that to the average domestic equity fund’s expense ratio of 1.26 percent, and the average fund carries a total cost burden of 2.22 percent.

Many, of course, have higher expenses and many have lower expenses. The researchers also found that transaction expenses consistently declined when dealing with larger funds, large-cap funds vs. small-cap or foreign funds, and index funds vs. managed funds.

What does it all mean? Costs matter. All costs matter. Without clear demonstrated management superiority, we’re better off index investing than choosing managers.

Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at scott@scottburns.com. Questions of general interest will be answered in future columns.