Tax-Free Income From Municipal-Bond CEFs: A Closer Look
Summary Municipal-bond closed-end funds offer excellent opportunities for high levels of tax-free income. This category is the largest in the closed-end fund space. Here I look in some detail at funds that rose to the top in an earlier filtering of the entire municipal bond CEF universse. A Closer Look at Top-Scoring Municipal Bond CEFs I recently discussed tax-free, municipal-bond, closed-end funds ( here ). Tax-free munis comprise the largest category of closed-end funds. Two sites ( Cefanalyzer and cefconnect ) were the primary sources for the previous report. They list 99 funds covering tax-free national municipal bonds with over $45 T in AUM, so narrowing down that lot to a manageable number of candidates to research can be daunting. I identified several that looked to be potentially appealing based primarily on criteria set out by Eli Mintz using the relationship between return on NAV and discount as a filter. Briefly, Mintz noted a modest linear relationship between the two metrics and argued that funds falling well below the linear trend line were most worth exploring when making new purchases. I received some excellent feedback in the comments to that article. In particular, several readers pointed to two Eaton-Vance funds as being among today’s best opportunities in tax-free CEFs. In this article I want to expand in greater detail some of the funds previously noted plus the two Eaton-Vance offerings. The funds I’ll discuss are: MFS High Yield Municipal Trust (NYSE: CMU ) Dreyfus Municipal Bond Infrastructure Fund, Inc. (NYSE: DMB ) Eaton Vance Municipal Bond Fund (NYSEMKT: EIM ) Eaton Vance Municipal Bond Fund Ii (NYSEMKT: EIV ) MFS Municipal Income Trust (NYSE: MFM ) Nuveen Municipal Advantage Fund Inc (NYSE: NMA ) Nuveen Municipal Market Opportunity Fund Inc (NYSE: NMO ) Nuveen Select Quality Municipal Fund Inc (NYSE: NQS ) Nuveen Dividend Advantage Municipal Fund 2 (NYSEMKT: NXZ ) Nuveen Dividend Advantage Municipal Fund 3 (NYSEMKT: NZF ) Invesco Trust For Investment Grade Municipals (NYSE: VGM ) Invesco Advantage Municipal Income Trust II (NYSEMKT: VKI ) Invesco Municipal Opportunity Trust (NYSE: VMO ) This is a mixed group with some focused on high yield, others on credit quality, others on duration. The funds that appeared most interesting using Mintz’s criteria, which emphasizes high NAV return and deep discounts tend to push further out on the credit-quality scale, have longer durations, and relative high percentages of their portfolios subject to AMT. As the appeal of these funds is tax-free income, the AMT issue can be a deal breaker for some investors. Here is a heat-map table summarizing Discount, Distributions, Net Investment Income, Average Portfolio Maturity and Leverage. (click to enlarge) The next chart compares credit quality among the funds. On the horizontal axis, I’ve listed the funds and, in parentheses, their average portfolio credit rating based on number of bonds (data from Morningstar ). (click to enlarge) The superior credit quality of the two Eaton-Vance funds (EIM, EIV) is clearly evident in this chart. The percentage of each portfolio’s bonds that is subject to AMT shows a wide range as seen in the next chart. EIM and EIV are zero-AMT funds. The MFS funds (CMU and MFM) carry the highest AMT liabilities at 24% for MFM and 22% for CMU. The Nuveen funds (NMA, NMO, NQS, NXZ and NZF) are lowest of the non-zero group with the Invesco funds (VGM, VKI and VMO) intermediate. EIM and EIV are zero-AMT funds. The MFS funds (CMU and MFM) carry the highest AMT liabilities at 24% for MFM and 22% for CMU. The Nuveen funds (NMA, NMO, NQS, NXZ and NZF) are lowest of the non-zero group with the Invesco funds (VGM, VKI and VMO) intermediate. The next table shows effective durations, unadjusted and adjusted for leverage: Effective Duration Unadjusted Adjusted for Leverage CMU 6.56 10.20 DMB 6.49 9.40 EIM 4.86 8.00 EIV 2.86 4.70 MFM 7.00 10.00 NMA 7.10 10.88 NMO 7.72 12.10 NQS 7.76 12.32 NXZ 7.47 11.31 NZF 8.29 12.80 VGM 7.97 13.44 VKI 7.71 12.97 VMO 7.82 13.11 Again, the Eaton-Vance funds, especially EIV, stand out from the pack. Summary The Drefus fund made this list on the basis of its deep discount (ranking 4th of the 99 funds screened) and a return on NAV near the median (51/99) which place it very high using the qualitative Mintz criteria. Leverage (10.39%) is low for this category (12/99), which helps to moderate risk for the fund. Duration is shorter than all but the Eaton-Vance funds, which reduces interest-rate risk relative to the rest of the pool. On the negative side, credit quality is low, averaging BBB- for the portfolio. Unfortunately, it has the highest negative net investment income in the field (99/99); the fund’s payout yield is 6.47%, but its actual yield is only 4.84%. One might reasonably expect a distribution cut soon. As the funds primary appeal is its high yield for low leverage, the specter of a dividend cut takes it out of my consideration. For investors primarily interested in high levels of tax-free income, the Invesco funds (VKI, VGM and VMO) might be most appealing. Next would come the MFS funds (CMU and MFM). VKI pays a tax-free 7.01% (2/99); excess NII is a negative -0.25%. The other two offer similar results. But these three funds use the highest levels of leverage to achieve those returns. For the entire universe of national tax-free CEFs, only 5 exceed 40% leverage, these three Invesco funds are among those five. For VKI, leverage is 40.54% (97/99) with VGM and VMO (96 and 95/99) only slightly behind. The MFS funds also offer high yields. CMU is paying 6.77% (11/99) and MFM pays 6.31% (47/99). Unlike the Invesco funds, they do so without paying shareholders more than they are taking in. CMU’s excess NII of 0.72% ranks 3/99 for the tax-free muni-bond CEF universe and MFM’s 0.49% ranks 6/99. It would appear their yields are safe for the near term. Leverage is moderate, CMU carries 35.56% (55/99) and MFM carries 30.04% (25/99). CMU’s average portfolio credit rating of BBB- is low, but not out of line with the Invesco funds. MFM is much better at BB+. None of these high-yielding funds would appeal to investors who place a high priority on minimizing AMT, however, as they are among the highest for this metric. The Nuveen funds carry deep discounts, which drive moderately high yields from less risky portfolios. Those discount range from the mid -13%s to the mid -14%s. and rank 5, 7, 8 and 13 of all 99 funds. This generates yield near 6% (5.93 to 6.09%) from moderate leverage (32.13 to 33.98%), which clusters the fund near the lower mid-range of leverage for all funds. Credit quality is intermediate for the group (all BBB average rated except NXZ at BBB-). I’ll close with the Eaton-Vance funds. These are clearly the best for a more conservative investor who is more interested in credit quality (A- for EIM and AA for EIV) than yield (6.28% for EIV, ranking 49/99 and 5.91% for EIV, 68/99). For investors subject to AMT, the fact that they are AMT free can enhance those yields on a tax-equivalent basis as well. Leverage is high, however; both fall into the top 10% of all funds. These funds did not make the cut in my initial analysis because that exercise depended heavily on Mintz’s relationships between NAV return and discount. From that point of view EIV falls directly on the trend line and EIM, with its greater discount, falls moderately below it. As respondents to my last article, especially wiseone123 and Johan2003 , point out these funds have strong portfolio, attractive yields and discounts and should be considered strong candidates by anyone looking for entries into muni-bond CEFs at this time. Thanks to the commenters on the previous article for their excellent feedback, especially with regard to the Eaton-Vance funds, which certainly appear to be the choice of the lot. If one were to follow Mintz’s lead, then EIM would probably be the better choice of the two, but this comes at the cost of reduced portfolio credit quality. The most conservative investor would likely choose EIV with its high credit quality, low duration and reasonably high yield. Even using Mintz’s criteria, the fund is a reasonable buy as it is not in the more problematic space above the trend line. (For discussion of the NAV distribution/discount relationship with a summary of all 99 funds, see my earlier article, linked above.) Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.