Five CEFs for Tax-Free New York Income

Although I'm now based in Chicago, I was born and raised in New York City. Such a large diversity of races, religions, and political persuasions live together in close proximity that the description of a "melting pot" has become cliche in describing the five boroughs. But, as different as New Yorkers are from each other, every investor currently living in the state has one thing in common: They do not enjoy paying taxes on their investment income. Even with the recent tax break for middle-class income earners, New Yorkers still pay one of the highest tax rates in the country. A resident of New York City who earns $80,000 in taxable income, for example, is subject to a 6.7% state tax and a 4.0% city tax on top of a 25% federal tax.

New Yorkers looking to escape this burden are in luck. A subset of closed-end funds, or CEFs, focus on New York municipal debt, which is exempt from both state and city taxes. (Some of these funds also invest in the debt of Guam and Puerto Rico, but oddly enough, this income is also exempt from state and city taxes.) An investor who buys one of these funds could take away between 27% and 93% more income.

Still, New Yorkers should consider the trade-offs of investing in a state fund over a national municipal fund. New York municipal funds provide extra tax exemption, but they are also riskier because their holdings are much more concentrated. If the New York State government became as fiscally inept as my new state (Illinois) or the geographic region fell into economic turmoil, the resulting credit quality of a New York municipal CEF would diminish significantly. The credit quality of a national municipal CEF, however, would not be as strongly affected, as its holdings would be spread across multiple states.

In any case, the default of New York State is unlikely. Going into fiscal year 2013, the state faces a $3.5 billion budget gap, but it has made substantial progress in closing this. At the beginning of fiscal 2012, this number was projected to be $15 billion. The state's general-obligation debt currently enjoys a AA (or Aa2) rating from the three major rating agencies, indicating that a default is unlikely. What's more, the state's 2013 budget has $700 million allocated toward municipal aid, lessening the likelihood of a default at the individual municipality level.

With 31 New York municipal CEFs, investors have a wide variety of choices. We have narrowed the field down to five CEFs that we believe are worthy of investors' consideration. We paid special attention to income. Because of leverage and portfolio quality, the following funds take on differing levels of risk and ultimately pay different distribution rates. We have selected funds with stable distributions that we believe are of above-average quality.

Nuveen NY Select Tax Free NXN
For investors with lower tolerance to volatility, Nuveen NY Select Tax Free is attractive because it uses exceptionally little leverage. Although this has led to lower absolute performance than that of its leveraged peers, the fund's returns have also been more stable. Over trailing one-, three-, and five-year periods, leveraged New York municipal CEFs had average NAV total returns of 24.1%, 12.8%, and 5.0%, while NXN had returns of 12.9%, 7.5%, and 5.1%. However, NXN's standard deviations of 2.0%, 2.1%, and 3.8% over the same periods were lower than the leveraged peer group averages of 3.6%, 4.5%, and 7.6%.

Similarly, NXN's distribution rate at share price of 4.5% is lower than the peer group average of 5.4%, but this is still high considering that none of this income is coming from leverage. Moreover, the distribution has been relatively stable over the past five years, increasing to $0.0545 per share from $0.051 per share. Although the fund's undistributed net investment income, or UNII, has been mostly negative over this time, it has been positive since June 2010 and has grown to a comfortable $0.0475 per share.

Portfolio manager Scott Romans has managed the fund only since February 2011, but he has been a portfolio manager since 2003. Moreover, Romans has not made substantial changes to the portfolio since he began his tenure. The fund had a turnover rate of 3% in fiscal 2011 and had turnover rates of 1% in fiscal 2001 and 2009. Moreover, the fund's low fees correspond to its passive management strategy, as it only charged an adjusted-expense ratio of 0.40% last year. Investors willing to give up some performance and distribution in return for less volatility and lower fees may find this fund interesting.

BlackRock NY Municipal Income BNY and BlackRock MuniYield NY Quality MYN
BlackRock NY Municipal Income and BlackRock MuniYield NY Quality each have leverage ratios (1.55 and 1.56) that are on par with the peer group average and also have higher-than-average distribution rates at share price.

Even though BNY is currently trading at an 8.7% premium, its 6.1% distribution rate at share price is among the highest of NY municipal CEFs. The distribution has been very stable, having slowly increased since 2001 to its current level of $0.0825 per share. Moreover, the fund has a nice UNII cushion of $0.2293 per share. The distribution has been paid almost entirely from income over this period (2007 included a special distribution of capital gains). Investors subject to the Alternative Minimum Tax should take note that 17.5% of this income is not exempt.

MYN was formerly an insured municipal fund, and about 70% of its portfolio is still composed of insured bonds. This means that credit risk is less pressing, but it also leads to a lower distribution rate of 5.7% at share price. The fund's distribution has been a bit rockier than BNY's, but it has increased by 35% over the past three years, to $0.071 from $0.0525. The fund's UNII of $0.1432 per share provides adequate coverage for its monthly distribution, but this is not as extensive as BNY’s coverage.

Both funds have had better-than-average returns, while only having to take on marginally higher volatility than peers do. BNY's NAV total return over one-, three-, and five-year periods was 24.7%, 14.8%, and 5.9%, while MYN's NAV total return grew 26.9%, 12.3%, and 6.1%. The funds' standard deviations were also higher than peer averages at 3.7%, 4.7%, and 7.6% (BNY) and 4.1%, 5.1%, and 8.1% (MYN) for the same periods.

The two funds are managed by Theodore Jaeckel and Walter O'Connor, who comanage about $20 billion of assets across 64 BlackRock funds, and Timothy Browse, who manages about $3 billion in assets across 13 funds. Jaeckel, O'Connor, and Browse have managed these funds since 2006. BNY and MYN charge adjusted expense ratios of 1.23% and 1.14%, respectively, close to the NY municipal CEF average of 1.25%.

Invesco VK NY Investment Grade Municipal VTN and Invesco NY Quality Municipal IQN
Invesco VK NY Investment Grade Municipal ties BNY for the highest distribution rate at share price on this list at 6.1%. Like BNY, this fund also has a large UNII at $0.3336 per share, providing ample coverage for its $0.084 distribution. The distribution has consistently increased and has been paid from income since 2006. Accompanying the higher distribution payments, the fund takes on slightly higher leverage (it has a leverage ratio of 1.58), and its weighted average credit rating of BBB- is slightly lower than the peer group average of BBB. As with BNY, AMT-liable investors should note that 11% of this income is not exempt from the tax.

Alternatively, Invesco NY Quality Municipal has a lower leverage ratio of 1.32 and an average credit quality of BBB. The 4.8% distribution rate at share price is below average, but, like VTN, it has very strong UNII coverage of $0.3871 per share compared with its monthly distribution of $0.065.

The performance of these two funds reflects their varying leverage. VTN's NAV generally had higher total returns than the average peer did, growing 27.9%, 15.8%, and 4.9% over trailing one-, three-, and five-year periods but also higher standard deviations of 4.2%, 5.2%, and 10.2%. Over the same periods, the less-leveraged IQN had average total returns of 22.5%, 12.3%, and 6.4%, with lower-than-average standard deviations of 3.4%, 4.1%, and 6.3%. The two funds are managed by the same team at Invesco, and each charges much lower-than-average fees. VTN has an adjusted-expense ratio of 0.95%, while IQN's 0.42% is the second lowest of the peer group.

These five funds should provide New Yorkers with a good starting point for finding tax-exempt income. There are certainly other New York municipal funds that are worth considering, but we believe these five CEFs offer the most attractive qualities.