An Overlooked Asset Class: Muni CEFs
This is about a niche market I find quite compelling. Most investors in the space fall prey to some common pitfalls, and I explain how to avoid them.
Part of my job is to generate income for people nearing or in retirement. A portion of my approach for investors with taxable wealth uses municipal bond closed-end funds (CEFs). Interest from muni bonds is exempt from federal income tax. So a 6% yield from a muni CEF is equivalent to a high earner making 10% pre-tax in bond income or short-term cap gains. 10% pre-tax was fairly easy to attain two decades ago. Now, not so much.
Most investors are familiar with open-end mutual funds. CEFs are different in that they 1) trade intraday like stocks and 2) can trade above or below the net asset value (NAV) of their underlying bond portfolio.
Think of CEFs as extremely simple companies. They IPO to raise money for an investment portfolio and then manage it for a fee. The NAV of the fund is the value of the company. If the CEF’s market price is less than its NAV, the fund is trading for less than its intrinsic value.
I prefer CEFs for long-term muni exposure because discounts can occasionally get quite wide. Plus, CEFs can use leverage to juice their yields (and risk). This article by Nuveen does a good job of detailing how CEFs employ leverage. Long story short: their short-term financing costs are typically SIFMA + 75bps. 80% of muni CEFs use leverage, and on average 50% of the fund’s NAV is borrowed against. For example, a CEF might own a bunch of long-term muni bonds yielding 5% and lever it up to yield 7.5%. After deducting 0.8% in interest expense (1.6% funding costs * 50% of portfolio) and 1.0% in management fees, the CEF will yield 5.7% net. If that CEF is bought for a 10% discount it will yield 6.3%.
Most muni CEFs look very similar under the hood. They typically own portfolios of long-term bonds, primarily investment-grade with just a bit of high yield mixed in. CEFs mainly differ in two ways: 1) what they actually yield and 2) if they’re trading at a discount or premium.
Distribution Yield vs. Earnings Yield
The CEF market is dominated by retail, not institutional, investors. Retail investors solely care about a fund’s yield. It’s why PIMCO CEFs with high yields persistently trade at a premium to their NAV. I think it’s a bit short-sighted to solely focus on the distribution yield. Most investors don’t know that a CEF can actually distribute more than they’re earning in bond interest. Each CEF has UNII, or unearned net investment income. Think of it as the CEF’s “piggy bank”. It can be positive or negative. If it is negative, a fund is distributing more than it’s earning. This is tolerable for a few quarters, but eventually the management team will have to step in and lower their distribution.
An investor seeing a a distribution yield of 6% when the earnings yield is only 5.2% is seeing an artificially high yield that will likely be cut. I personally screen for muni CEFs that are at the minimum earning 100% of their distribution yield.
Discounts and Premiums
All else equal, a wide discount is a good thing. It means you’re buying assets for less than they’re worth. CEF discounts are a function of investor sentiment. In periods like 2008 and late 2013, discounts blew out and you could buy muni CEFs for 15% below their NAV. Conversely, periods like 2012 and early 2013 saw most CEFs trade at a premium when markets were calm and people were chasing for yield.
If a CEF is trading for a 5% discount you shouldn’t necessarily expect that discount to narrow. Sometimes it happens, sometimes it doesn’t. That’s why when evaluating CEFs I look at: 1) the absolute discount 2) the discount relative to the CEF’s historical discount. I assign an equal weight to each. The best situation would be a large absolute discount and a historically wide discount relative to a fund’s history.
The two primary risks in any fixed income investment are credit risk and interest rate risk. Muni CEFs have much more of the latter since they leverage up long-term bonds. The average leveraged-adjusted duration for muni CEFs hovers around ~12. This is high and means that muni CEFs will sell off if long-term rates rise. As an example, here are drawdown stats for S-Network’s Muni CEF Index and TLT during the 2013 taper tantrum. TLT has a higher duration, so why did muni CEFs sell off more? Mainly because discounts widened by an additional ~10%.
When Muni CEFs Thrive
I don’t advocate having a static allocation to muni CEFs. The absolute best time to have exposure is after long-term rates have spiked and when discounts are substantial. This happened last winter. The chart below shows the six-month change in 30-year Treasury yields and the historical discount or premium of NAD, a popular muni CEF.
As you can see, yields spiked and discounts were wide. In contrast, late 2011 was an example of a poor environment for muni CEFs: long-term rates had imploded and discounts were non-existent.
Muni CEFs are an extremely small slice of the overall bond market and they do carry material interest rate risk. That being said, I think most investors would be hard-pressed to beat their after-tax yields, especially compared to the benchmark Barclays Aggregate yielding ~1.5% after taxes.
Muni CEF exposure makes sense after rates have risen and when discounts are wide. Within the 80 or so muni CEFs, there are only a handful of funds 1) actually earning their distribution yield and 2) selling at an attractive discount. Each quarter, I rebalance client accounts into the 3–5 CEFs that meet my criteria.
Additionally, there are low cost ways to hedge the interest rate risk inherent in muni CEFs. If you’re interested in more details on the hedging process or about my muni CEF model, send me an e-mail at adam at movement dot capital