Tax-Free Income From Municipal Bond CEFs
Municipal bond CEFs can provide attractive yields free from federal taxes. I survey the tax-free CEF category in this report. The category has seen an upsurge in interest which has begun to take a toll on the attractiveness of some funds. Tax Free Income I’ve been spending a lot of time looking at tax-free-income, closed-end funds (municipal bonds) recently. It would appear that I am not alone. For the last two months, muni bond CEFs have sustained the highest relative strength index of all CEF categories as classified at ETF Screen . This chart showing RSI for CEF categories is built from their data. (click to enlarge) I find it interesting that the upsurge in RSI for muni bond CEFs dates from just about the time I wrote a series about them ( Tax Free Income from Municipal Bond Closed End Funds ) in mid-August when I felt the category was rife with bargains. It seemed clear to me at the time that the category was ready to move up. In light of the intense interest the data in the chart indicates, I thought I’d take another look. Keep in mind, however, that chart technicians tend to see RSI values this high as an indication of being overbought, so the chart may well be trying to tell us that this is not the time to be adding municipal bond CEFs. As I’ve done in the past I want to try to paint a graphic picture of the space and follow up with a brief look at some funds that look interesting. I’ll follow up in a few days with details on specific funds. First, a look at distributions. Here’s the spread for the whole muni bond category of CEFs. (click to enlarge) To put the tax-free return in perspective, I’ll add this table of equivalent taxable returns for federal tax rates assuming normal interest income. (click to enlarge) Regular readers know that I like to buy funds at a discount, especially at a discount that is outsized relative to the fund’s recent history. This chart shows the current distribution of discounts and premiums for the 99 funds in the category as listed on CEFanalyzer . (click to enlarge) Over the past six weeks the range has shifted toward lesser discounts. The average discount has lost two points. Discount/Premium 25-Aug 12-Oct Average -8.81% -6.84% Median -9.86% -8.31% Low -14.68% -13.12% High 7.36% 12.87% Z-Scores tell us a lot about the directions discounts and premiums are moving. Here are current Z-score distributions for 3, 6, and 12 months. (click to enlarge) (click to enlarge) (click to enlarge) What we see is a strong shift over the past year toward more positive Z-scores demonstrating reversion to the mean for discount/premiums across the category. A year ago the median Z-scores stood at -1.43%; today it is 0.13. Another interesting metric is the relationship between NAV distribution and discount. What makes this indicator valuable is the tendency for CEFs to move toward some price distribution yield equilibrium through adjustments of discount status. CEF investors are primarily investing in the income. We see the repeated occurrence of high discounts on funds with lower distributions on NAV as buyers are less willing to pay for the lesser income distributions. Similarly more modest discounts, even premiums are found on funds with higher distributions on NAV. This relationship is seen in the next chart. I’ve added labels, but the amount of information here is such that the labels are in many cases, unreadable at this scale. The primary point of the chart is to show the overall relationship, so it should not matter except at the edges, which are readable. I’ll zoom in on the most interesting cluster next. (click to enlarge) The trend line here shows the positive relationship between NAV distribution and discount/premium. Funds that lie below the trend line tend to present more attractive entry points than those above the trend line. That is not to say that funds above the line are unacceptable for purchase. There are many complex factors that go into the market’s pricing of any given fund, distribution yield is only one, an important one but not the only one. The r 2 for the linear trend is only 0.15, so this relationship only accounts for 15% of the variation in discount/premium. Quality factors especially will often override the tendency shown in this chart. A fund might be priced at a lesser discount because, for example, has a more attractive portfolio on credit quality or effective duration. My own bias is to avoid funds at the upper ranges of distance from the trend line and to use this chart to identify candidates for a closer look. With that in mind, let’s look at that dense cluster crowded around the -10% discount and 5.5% NAV distribution point. (click to enlarge) I’ll note here that some of my favorite funds lie just above that line: The Dreyfus Strategic Municipals (NYSE: LEO ) and the Blackrock Investment Quality Municipal Trust (NYSE: BKN ) are two that I have owned in the past and I consider them both to be good funds. Note that the cluster most distant from the line holds a large fraction of Nuveen funds. I don’t know why it is, but Nuveen funds seem to hold deep discounts over long time frames. Last time I looked at this, I picked out 13 for a closer look. Five of these were Nuveen funds which, as I noted, tend to carry a perennially deep discount, so this is not a great indicator for those funds. Those 13: The MFS High Yield Municipal Trust (NYSE: CMU ) and the Municipal Income (NYSE: MFM ); the Dreyfus Muni Bond Infrastructure (NYSE: DMB ); the Eaton Vance Municipal Bond I (NYSEMKT: EIM ) and II (NYSEMKT: EIV ); Nuveen’s Muni Advantage (NYSE: NMA ), Muni Mkt Opps (NYSE: NMO ), Select Quality Muni (NYSE: NQS ), Dividend Advantage 2 (NYSEMKT: NXZ ) and 3 (NYSEMKT: NZF ); and Invesco’s Muni Investment Grade T (NYSE: VGM ), Adv Muni II (NYSEMKT: VKI ) and Muni Opps Trust (NYSE: VMO ). The 13 funds have a total gain of 2.51% which sounds good until I add that the entire muni bond space averaged 2.41% over the same time frame. Here are those 13 and their returns since that time. The funds in green beat the category average. Note that if we drop the Nuveen funds from consideration, the average goes to 3.05%. That’s not to say that Nuveen funds should be avoided, merely that I don’t think this indicator applies as well to them as it does to funds with more volatile discounts. If we look at the Nuveen funds alone it turns out there is no correlation between discount and NAV distribution. (click to enlarge) This suggests that the indicator has no value for evaluating Nuveen’s muni bond funds. There are other factors driving discount dynamics that are more important for this set of funds. Of course discounts alone are not sufficient to make a decision on a fund. Duration is an important consideration, especially with interest rate anxiety so prevalent in everyone’s thinking. The nature of how data is reported means that one can only screen on average maturity, which is a much less telling metric than effective duration. The top five funds for portfolio maturity and a distribution greater than 5% are the Deutsche Municipal Income (NYSE: KSM ), the Deutsche Strategic Muni Income (NYSE: KTF ), the AllianceBernstein Nat Muni (NYSE: AFB ), the EV Municipal Bond II and the Putnam Municipal Opportunities (NYSE: PMO ). Working from this list, we can go to Morningstar where effective duration, leveraged and unleveraged, plus weighted average credit ratings for the portfolios can be found. Note that Morningstar’s weighted credit rating score may differ from that of other sources as their weighting system more heavily weights lower credit quality holdings. (click to enlarge) We see that the screenable metric, maturity, is a poor predictor of the more relevant metric, duration, but it’s the best starting point we have for a group of funds this size. EIV would seem to be the choice here. It rose to the top at my last look and it is still there today. It is paying 5.9%, somewhat under the category median of 6.1% and right on the category median. The discount just beats the median of -8.31%. Portfolio maturity is in the top 10 and effective leverage is the best of the five top funds for average maturity and distribution greater than 5%. Its weighted average credit rating is the best of the lot. Also worth noting is that EIV is an AMT free fund. The two Deutsche Investment Management Americas funds (KSM and KTF) are interesting. They are yielding about a half point more than EIV. Their modest discounts, especially KSM, and lesser credit quality puts them a step behind EIV for me. KTF beats KSM on credit quality and discount, but lags on distribution and duration, so it’s a bit of a wash choice between the two. Expenses on the Deutsche funds are modest at 0.64%, well below EIV (1.20%), AFB (1.04%) and PMO (0.96%). Leverage for each of these is in the mid 30% range which is typical of the category. For those who prefer to avoid leverage, there are two funds with under 2% leverage. They also have the shortest portfolio maturities in the category. As expected they have significantly reduced yields relative to the leveraged funds. These are the BlackRock Muni 2018 Term Trust (NYSE: BPK ) and the Nuveen Select Maturities Muni (NYSE: NIM ). (click to enlarge) Fees on these two funds are low, 0.64% for BPK and 0.58% for NIM. Yields are, as noted, low relative to the leveraged CEFs, but competitive with unleveraged municipal bond ETFs such as the iShares National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) which has an effective duration of 6.34 years, weighted average credit rating of AA, and at 2.58% yields significantly below either of these two funds. It is AMT free, however. BPK is 28% subject to AMT, but NIM is only 3.2%. I’ll be back with a closer look at interesting funds that may provide attractive entry points at this time.