Dear Mr. Berko: For the past few weeks, I have been watching BlackRock MuniAssets Fund trading between $13.46 and $13.85. It seems very steady, and the income has also been very steady over the past five years. It pays 6.25 cents monthly, which is a 5.4 percent tax-free yield, and that’s very attractive. How can it get this kind of tax-free yield when the best tax-free bonds my broker can find yield only 3 percent? I have $65,000 to invest from an annuity I owned for 10 years.
— P.L., Kankakee, Ill.
Dear P.L.: Municipal accounting and municipal balance sheets are a foreign language to most investors. So investing in the municipal high-yield junk-bond market is like wearing stilts to walk safely across a field of land mines. And considering allegations that Standard & Poor’s has, for a fee, ignored accounting statement deficiencies and assigned high ratings to low-quality bonds, reputable brokerages prefer to limit their sales forces’ access to these investments.
BlackRock MuniAssets Fund (MUA-$13.46) can earn that high of a yield for two reasons: 1) It only purchases high-yielding junk bonds, with coupons in excess of 5 percent, most of which are not rated by Moody’s Investors Service or S&P. 2) The use of leverage, which is explained below.
Like most closed-end bond funds, MUA uses leverage to increase its yield. MUA’s portfolio manager borrows short-term funds at low interest rates to purchase long-term municipal bonds at higher interest rates, and this process is called leverage. Assume MUA has $100 million invested in a portfolio of 20 municipal bonds producing an average yield of 5 percent, or $5 million of tax-free interest a year. The portfolio manager, with MUA’s $100 million portfolio as security, borrows $12 million (12 percent of the portfolio’s value) from a bank at 2 percent and uses this loan to buy $12 million of additional municipal bonds paying 5 percent. MUA now owns a portfolio valued at $112 million in which it has invested only $100 million. And this leverage, if used wisely, can smartly increase the portfolio’s yield. MUA’s short-term $12 million borrowing will cost it (2 percent times $12 million) $240,000 in interest. But the $12 million in newly purchased municipal bonds will earn MUA an additional 5 percent, or $600,000 of interest. So when collecting $600,000 of extra interest income from the new municipal bonds and subtracting the $240,000 of interest cost, MUA’s portfolio will net an extra $360,000 of interest income. This extra $360,000 of interest income will be added to the $5 million of interest that MUA’s portfolio will earn, so the total interest earned by MUA will increase from $5 million to $5.36 million. And a tax-free income of $5.36 million on an investment of $100 million equals a dividend yield of 5.36 percent.