Muni closed-end funds are a type of mutual fund that only contains municipal bonds. Mutual funds are generally bought and sold once a day after the stock market closes, whereas muni closed-end funds are traded like stocks, which means shares can be bought and sold throughout the day. People in high tax brackets often buy this type of funds because these investments pay dividends that are usually non-taxable.
Municipalities sell two types of bonds: general obligation bonds and revenue bonds. Government entities sell general obligation bonds to raise money for short-term expenses, such as payroll and law enforcement. Bondholders loan money to the government for a period of time, and the government pays bondholders interest payments derived from taxes. Revenue bonds are sold to raise money for income generating municipal projects, such as airports. Bondholders receive interest payments based upon income generated by the completed project.
In the United States, the federal government does not assess taxes on either municipal bond interest payments or dividends paid by muni closed-end funds. Investors who buy bonds issued by a local government, based in the state where they live, do not have to pay state income tax on the interest. People with high tax burdens often buy municipal bonds or muni closed-end funds to take advantage of these tax breaks.
Muni closed-end funds begin with an initial public offering during which shares are sold to investors and funds are raised to buy the underlying municipal bonds. Investors cannot buy into the fund after the initial public offering, but can buy shares on the secondary market from existing shareholders. Muni funds pay a regular dividend that is based on interest payments the fund company receives for the bonds it holds.
The main benefit that muni closed-end funds have over individual municipal bonds is diversity. If either a project financed with revenue bonds or a municipal government goes bankrupt, the bondholders stand to lose all of their money. Muni closed-end funds contain thousands of bonds issued by different government entities, so if one city government goes bankrupt it impacts the fund but does not cause the shareholders to lose their entire investment.
The share prices of muni closed-end funds are in part based upon the value of the underlying bonds, but are also contingent upon supply and demand. Shareholders have to negotiate a sale price when selling shares. During a booming market, a shareholder may be able to sell a share at a premium whereas during a market downturn, shareholders often have to sell a share for less than its true value.