RFMZ: Evaluating Return of Capital and Its Impact on Investor Returns

The RiverNorth Flexible Municipal Income Fund II (RFMZ) has garnered attention for its high distribution rate and tax-exempt structure, but its reliance on return of capital raises critical questions about tax efficiency and the long-term sustainability of its payouts. As market volatility intensifies in 2025 and investor demand for sustainable strategies grows, understanding how RFMZ balances these factors is essential for assessing its value proposition.

Tax Efficiency: The Double-Edged Sword of Return of Capital

RFMZ's distribution strategy is anchored in its municipal bond holdings, which generate income exempt from U.S. federal income taxes. However, a significant portion of its distributions-approximately 59.93% as of September 30, 2025-consists of return of capital, which reduces the fund's net assets and is not taxed until the investor's cost basis is exhausted according to Morningstar. While this structure allows RFMZ to maintain its monthly payouts, it also means shareholders are effectively recouping part of their initial investment rather than receiving taxable or tax-exempt income.

This dynamic has implications for tax efficiency. For instance, return of capital distributions may lower the fund's expense ratio by reducing the need for new capital generation but could also amplify the tax burden if the remaining components of distributions are subject to the alternative minimum tax (AMT) for certain shareholders as research shows. Additionally, the fund's leverage-41.94% of its portfolio as of August 2025-introduces complexity, as borrowed capital can distort the tax treatment of returns and increase risk during market downturns according to CEFConnect.

Sustainability of Distributions: Balancing High Yields and NAV Performance

RFMZ's 8.01% distribution rate, while attractive, must be weighed against its negative total return on net asset value (NAV) of -4.73% as reported by CEFConnect. This discrepancy highlights the tension between maintaining consistent payouts and preserving capital. The fund's managed distribution policy aims to stabilize returns, but its reliance on return of capital suggests that income generation from municipal bonds may be insufficient to sustain distributions without eroding NAV.

Comparative analysis reveals that sustainable funds, which prioritize ESG factors and durable dividends, have outperformed traditional funds in 2025, achieving a median return of 12.5% versus 9.2% according to Morgan Stanley. While RFMZ's focus on tax-exempt income aligns with this trend, its dual strategy of investing in municipal bonds and closed-end funds introduces credit and interest rate risks that could undermine long-term sustainability. Investors must assess whether the fund's leverage and market exposure can withstand prolonged volatility without compromising its payout consistency.

Market Volatility and Strategic Adaptation

The 2025 market environment, marked by political uncertainty and shifting interest rates, has amplified the importance of tax-efficient strategies. RFMZ's structure allows it to navigate these challenges by leveraging municipal bonds' tax advantages and its closed-end fund investments' potential for capital appreciation. However, its high return of capital component may limit flexibility during downturns, as reducing distributions could accelerate NAV erosion.

Tax-loss harvesting and strategic gifting have emerged as critical tools for investors in volatile markets according to Raymond James, and RFMZ's tax-exempt framework could complement these strategies. For example, return of capital distributions might be paired with Roth conversions or GRATs to optimize after-tax returns. Yet, the fund's sustainability hinges on its ability to adapt to regulatory shifts, such as potential modifications to the TCJA or SALT deduction caps, which could alter its tax advantages.

Conclusion: A Nuanced Assessment for Informed Investors

RFMZ offers a compelling case study in the interplay between tax efficiency and distribution sustainability. Its high yield and tax-exempt structure provide immediate benefits, but the prevalence of return of capital and leverage necessitate careful scrutiny. Investors seeking resilience in uncertain markets may find value in RFMZ's strategy, provided they are prepared for the risks of NAV compression and regulatory uncertainty. As sustainable investing continues to gain traction, RFMZ's ability to align its distribution model with evolving investor expectations will be pivotal to its long-term success.