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Summary My recent coverage of national, tax-free municipal bond CEFs failed to take note of two funds from Deutsche Financial. These two funds are fully competitive with the rest of the category and deserve full consideration by tax-free bond fund investors. The score especially well for yield vs average duration and average credit quality of their portfolios. Once more unto the breach, dear friends, once more… — Shakespeare, Henry V Here I thought I’d made my way through tax-free, municipal- bond closed-end funds for this cycle and I find I missed a couple of good ones. Thanks to the readers who pointed this out ( JuniorEnergyFund and bcbucks ). I missed two funds from Deutsche Investment Management Americas, both of which are worthy of inclusion in the list of national, AMT-free CEFs. So, I’ll extend this discussion one more round to run down the information on these two in the context of what we saw for the other 14 AMT-free CEFs previously ( AMT-Free Muni-Bond CEFs: Portfolio Quality ). The new funds for our list are the Deutsche Municipal Income Trust (NYSE: KTF ) and the Deutsche Strategic Municipal Income Trust (NYSE: KSM ). KTF has total net assets of $725.445M; KSM holds total net assets of $213.458M. The funds have been in existence since 1989 and 1988, so we have more than 25 years of history on them. I will start with a look at these two in relation to the rest of the AMT-free category. Distribution (click to enlarge) As shown here, distributions are at the top of the category. Only two funds from PIMCO — the PIMCO Municipal Income Fund III (NYSE: PMX ) and the PIMCO Municipal Income Fund (NYSE: PMF ) – beat KSM. KTF is only one behind with the Blackrock Municipal Bond Investment Trust (NYSE: BIE ), returning 6bps more, in between and tied with the third PIMCO fund, the PIMCO Municipal Income Fund II (NYSE: PML ). Those keeping score at home will recall we called out PML earlier, noting that its combination of excellent yield and reasonable premium/discount status pushed it to the top of the high-yielding funds. As I proceed we’ll see how these two stack up against it. Premium/Discount We see in the distribution chart that PMX and PMF have the highest yields but are also priced at a premium (NAV yield is greater than market yield). Some are unconcerned about paying a premium; I try to avoid it unless the fund is so outstanding and has so few alternatives that it starts to make sense. KSM pays essentially the same as PMF, the fund with the greatest premium, and pays 14bps under PMX which has a 13% premium. Here is the discount/premium sort for the category. (click to enlarge) As we see, KTF and KSM have small discounts. BIE, the other top yielder has the second deepest discount at -10.3%. It looks like a potential bargain were it not for the fact that BIE has been running a discount in the high single- to low double-digits since 2013, a pattern that tends to take some of the shine off a deep discount in my estimation. However, a look at the distribution chart does demonstrate the power of a deep discount: BIE has a yield on NAV mid-pack, but that discount jacks up the payout to shareholders to rank with the leaders. Distribution Sustainability High distributions are all well and good, but in today’s environment, one has to be concerned about the sustainability of the distribution as well. A good indicator for discount sustainability is UNII (undistributed net investment income). As we saw previously, none of these funds is showing serious danger signs for this indicator. All but three are positive, and the three than dip into negative territory do not drop deeply into it. KTF is well ahead of the pack. With UNII at 47.0% of its distribution it trails only PML’s 61.4%. KSM has a healthy UNII of 7.9% of its distribution. In this regard, we should note that KSM has recently cut its distribution. The August payment went from $0.077/share to $0.070. This was a drop of 9.1%. Cuts in muni-bond fund distributions have been occurring recently. It is a reflection of the low-interest rate climate we are immersed in. These funds have bond turnover and funds with shorter durations have more frequent turnover. As bonds turnover they are being replaced with bonds having lower coupon rates. It’s no different than an individual’s bond ladder; as rates fall, the yield of the total bond ladder falls as well. It’s my view that a fund that undertakes modest reductions in distribution pay-outs in a timely manner is better managed than one that drags it out until massive cuts become inevitable (see this discussion for recent examples of consequences to shareholders of funds’ waiting too long and cutting steeply all at once). Portfolio Quality I’ve been focusing on two aspects of portfolio quality: Credit ratings and bond duration. The data I’m using are from Morningstar , which rates bond fund portfolios using a weighted average credit rating. This over weights lower credit ratings and tends to be more conservative than other sources. They are also the only source I know that provides the most relevant metric for portfolio duration: Effective duration adjusted for leverage. I’ll start with duration. Investors with concerns about interest rate risk in the face of looming upticks in rates will prioritize shorter durations. The pattern for bonds is to follow the yield curve with shorter durations paying lesser yields. This curve is apparent in the NAV yields for the funds when plotted against effective duration. (click to enlarge) But, as we see the market distribution rate shows no correlation at all with duration. This would certainly appear to support the conventional wisdom that CEF investors ignore subtleties (if one can consider as fundamental a metric as duration to be a subtle component of a bond fund) in favor of yield. But, setting the lack of sophistication by CEF investors aside, what else we see here is that for this metric KSM and KTF are the real bargains of the category. Several of the Blackrock funds come close at market yields but their NAVs lies solidly on the trendline. The higher yield at NAV for comparable duration is a category won by Deutsche’s funds at the short end of the duration scale, and by PIMCO at the long end. How we get that anomalous yield curve on market yield obviously is a function of premiums and discounts as we see here. (click to enlarge) I’ll leave it to you, the reader, to sort out the logic of longer duration funds meriting premium valuations, but at least those premium funds are paying a reasonable return for the interest-rate risk associated with their longer durations. Oddly enough we see a similar, albeit less extreme, anomaly for credit risk. Lower quality credit carries high distribution yield as it should. We see that in the NAV values in this chart plotting yields against credit quality. (click to enlarge) But notice how the slope of the market yield trendline drops relative to the NAV trendline. Again, we see a willingness by investors to overpay for the higher yields that come with taking on credit risk. One could argue that credit risk for municipal bonds is vanishingly small, so it is reasonable to accept the risk and even to overpay for its higher return. Because, despite the regular doom and gloom about looming bankruptcies in the nation’s municipalities, the fact is that muni-bond defaults at the lowest investment-grade levels are much, much lower than comparable corporate bonds. Our focus funds, KTF and KSM sit in the mid to lower end of the credit-risk spectrum with weighted averages of BBB+ and BBB- . And, as for duration, both funds are above the trendlines for yield. Here is the premium/discount relationship to credit rating. As we saw with duration, higher premiums are associated with lesser credit quality. (click to enlarge) NAV Yield and Premium/Discount Fixed-income CEF investors value yield, seemingly above all else. There is a recurring relationship between yield at NAV and premium/discount where funds with higher yields at NAV command higher prices at market leaving them less discounted or even with a premium. This relationship is shown here. This trend is so prevalent that it can be used as an indicator of funds that deserve a close look, with funds falling under the trendline showing a more positive status than those above it. By this measure BIE is once again giving us a bit of a ‘come hither’ glance and demanding to be looked at. KTF is right on the trendline and KSM is a bit below it. I suspect that the fallout from the KSM dividend cut is still settling and it may show movement toward the line in the coming months. Summary Both KFT and KSM rank with the best of the category. While not heavily discounted, they do provide excellent risk-adjusted yields when seen in the light of their portfolios. Readers less concerned about the two risk factors discussed will want to look at PML, in my view the best opportunity from PIMCO right now. And BIE deserves mention as a potentially under valued CEF. I am grateful to my readers for having pointed out my omission of KFT and KSM in the previous articles and am glad to have had the opportunity to get them on the record. They are worth your consideration if this is a category that fits your investment strategies. Scalper1 News
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