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There Are Few Bargains In Tax-Free Income… Here’s 3

Summary Municipal bonds are coming off one of their best years in a long time. Most municipal bond, closed-end funds are selling well above their usual discount/premium status, a situation nearly exactly opposite that of a few months past. In this article I consider three funds that still present attractive valuations and propose one as my top choice. Few Bargains in Tax-Free Income. Here’s Three. After a dismal 2013, municipal-bond closed-end funds turned in a strong showing in 2014. Let’s start by looking at the largest and most liquid municipal bond ETF as a benchmark. iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) is up 5.42% for the past 12 months and has a 12 month tax-free yield of 2.74%. Not bad for muni bonds, but it doesn’t sound all that terrific, does it? Now, compare that to the median national municipal-bond closed-end fund: 12 month price return of 17.09% coupled with a current, tax-free yield of 5.87%. That’s a total return difference of nearly three fold. How is it that closed-end funds outperformed the benchmark ETF to such an extent? First is their use of leverage: the median muni-bond CEF is leveraged at 34.9%. This can provide a substantial boost in a year such as 2014 but will, of course, drag a fund’s performance down in a less favorable year such as 2013. A second factor is credit quality. Many CEFs will delve more deeply into the credit risk pool than MUB which holds 83% of its portfolio in bonds rated A and above compared to the category average of 74%. Here again, when things go well taking on credit risk can pay off. But in 2013 exaggerated fears of credit risk, driven largely by sentsationalist media coverage of the municipal bond market, proved costly to investors in this asset class. Finally, there’s the factor unique to CEFs: most sell at a discount to their NAVs. This cuts two ways: A discount pumps up the yield on NAV; buying a fund that pays, say, 6% on NAV at a 10% discount turns that 6% into 6.67% at market price. Plus, if a discount compresses, the holder of the fund enjoys capital appreciation unrelated to the price movements of the underlying assets. The first two factors, leverage and portfolio quality, tend to be stable for any given fund. The third, premium/discount status, tends to be quite volatile for municipal bond CEFs, and will often offer attractive buying opportunities. The strong showing for municipal bond CEFs over the last year, and the past few months in particular, has been driven in considerable part by discount compression. This has left few bargains for the tax-free income shopper. The median discount for national municipal-bond CEFs stands at -6.81%. Nearly -7% may look good at first glance but it compares poorly with recent history for the category. How poorly? That -6.81% is more than 2 standard deviations higher (i.e. less discounted) than the median discounts of 3 or 6 months ago. Such numbers do not offer much of an attractive market for buyers. Recent Changes in Premium/Discount Status in Municipal Bond CEFs The metric used to measure how a closed-end fund’s current premium/discount relates to its recent history is the Z-score which indicates how far from the average discount or premium a fund’s current discount or premium is. A fund with a positive Z-score is currently trading at discount or premium higher than its average. Negative Z-scores indicate distance below the average (deeper discounts). Only 4 months ago, when I last wrote about muni-bond CEFs, negative Z-scores were overwhelmingly the rule. That’s now turned around completely with the median Z-scores for 3, 6 and 12 months standing at 2.26, 2.17 and 0.97, respectively. This chart shows distributions of Z-scores for 3 and 6 month periods for 99 national municipal-bond closed-end funds. To see mean reversion in action, it’s worth comparing these to charts of the same metric in Figure 2 from October 2014 which present nearly exact mirror images of these charts in shape if not scale. Figure 1. Z-score distributions for national municipal-bond closed-end funds. In the entire universe of municipal-bond closed-end funds 5% have discounts deeper than their average for the last 3 months and only 8% for the 6 month average. A Moderate Fund-Trading Strategy for Muni-Bond CEFs That Combines Tax-Free Income and Periodic Capital Profits I consider closed-end funds to provide the best choice for exposure to tax-free income. I would argue that the municipal bond arena is the space where CEFs are the clear investment option of choice. They return consistently high-distribution yields on an absolute measure, and very high yields on a tax-adjusted basis in an investment category typified by low yield for essentially every other investment vehicle. Because CEFs often use high leverage and credit-risk as mechanisms to achieve those high returns they tend to be riskier alternatives in comparison with municipal-bond ETFs or holding individual bonds. To moderate some of that risk, I buy muni-bond closed-end funds when they are priced attractively relative to their typical discounts/premiums. To this end I rely on Z-scores to provide a measure of that relationship. I base this on an assumption that the funds with outsized Z-scores will tend to revert to their means over time. Some readers object to this emphasis on Z-scores, which I can appreciate. For the buy-and-hold investor they may be a relatively minor factor in an investment decision. But, I have been able to identify appealing opportunities by including this metric along with the more important considerations of yield and portfolio quality. Understand, as well, that I am always prepared to trade out of a fund if that carefully selected extreme discount reverts to the fund’s less deeply discounted mean, which is, in fact, what I expect to happen most of the time. An investor less inclined to trade funds will, of course, be less inclined to value this metric. Over the past few years I have purchased funds at outsized discounts and sold them at a profit as they reverted to something closer to their mean discounts, using the proceeds to purchase other funds with attractive entry points. With about 100 national muni-bond CEFs and another couple of dozen funds from my home state of California to select from there is always a lot of choice. This approach has provided steady, tax-free income in the 6 to 7% range and modest profits as I traded into new funds. By following this strategy, I presently hold muni-bond funds purchased when they had deeply negative Z-scores. Riding the rising tide in the asset class, they have logged substantial capital appreciation, a fair portion of which is attributable to mean reversion of their discounts. In fact they presently have Z-scores well over 2, so I would like to trade out of them and capture those profits. But there are precious few funds that meet the standards I’m looking for in a replacement. Screen Criteria and Results Can we find some reasonable buys in spite of the clear lack of the sorts of bargains that were available in the recent past? To find out, I downloaded the full list of national muni-bond CEFs from cefanlayzer.com and screened them using the following criteria: Market price yield at or above the median of 5.87%. Discount at or below the median of -6.81%. Z-score for 1, 6 and 12 months being negative for at least 2 of the 3 periods. These are pretty open filters. A few months ago they would have returned dozens of selections to explore. Today the screen passed only two funds: BlackRock Strategic Municipal Trust (NYSE: BSD ) and Dreyfus Strategic Municipal Bond Fund (NYSE: DSM ). With so few candidates, I opened the filter a bit more, stretching the market-price yield down to 5.80%, a bit below the median yield of 5.87%. This added a third candidate, Eaton Vance Municipal Bond Fund II (NYSEMKT: EIV ). This table summarizes yield on market-price, discount and Z-score values for the three funds. Figure 2. Yield, Discount and Z-Scores (Source: cefanlayzer.com ). When I write about tax-free municipal bond funds I like to show the equivalent tax-free yields for investors at a range of marginal tax rates, which I feel gives a better sense of how appropriate a yield point may be in for any individual’s case. Here’s the table. Figure 3. Taxable equivalents for Federal Marginal Tax Rates. As you can see, for an investor in the mid to upper tax brackets, the CEFs are providing extremely attractive tax-adjusted yields compared to what’s available in today’s fixed-income environment. Even at the lowest tax brackets one would be hard pressed to find fixed-income investments with comparable yield and safety. The Funds This next table summarizes some key features of each of the three closed-end funds under consideration. Figure 4. Leverage, Maturity, Duration, Credit Quality and Morningstar Ratings (Sources: cefanalyzer.com and Morningstar). BlackRock Strategic Municipal Trust has been selling at a discount between -4 and -8% since mid-2013. It’s current discount reflects a move upward from a low of -9.84% in August 2014. Distributions are paid monthly and have been steady at $0.074/share since 2010. The fund has not paid out return of capital since its inception. The top 5 states represented are Texas (13.3%), Illinois (11.2%), New York (9.2%), California (8.7%), New Jersey (6.1%). Tobacco bonds, generally considered the riskiest of muni bond categories, are not included in the top 5 sectors held in the portfolio. Morningstar rates the fund as having high to above average risk. The fund has a Sharpe ratio of 1.63 relative to the benchmark Barclays Index of 1.14. Dreyfus Strategic Municipal Bond Fund has been selling at a discount near -5% since early in 2013. Its present discount of -6.8% is marginally lower than its recent history and a full standard deviation below its one year average discount. Distributions are paid monthly. They were cut from $0.0475 to $0.0415/share in November 2014. The fund does not pay any return of capital in its distributions. Top five states are Texas (15.2%), California (12.6%), New York (11.8%), Massachusetts (8.1%), and Arizona ((4.5%). Morningstar rates the fund as having average risk. The fund’s Sharpe ratio is 1.09 relative to the benchmark’s 1.14. Some might express concern about the lead role of Texas in these two portfolios in light of the possible negative impacts of the oil crash on local municipal revenues. It’s just about impossible to sort out how much or little of a factor this may be. My inclination is to dismiss this as an immediate worry. Municipal bond default rates are so low relative to essentially all other bond categories, that I consider this risk exceptionally low on the list of possible risks for the funds. Eaton Vance Municipal Bond Fund II is the final of the three funds. It has seen its discount move to -8.1% at present which is above the -9% range it fell to during November and December 2014. Otherwise it’s about as low as it has been since late 2013. This is just short of one standard deviation below its 12 month average discount. The fund’s monthly $0.0631/share distribution has held steady since a drop in 2012. The fund does not pay return of capital in its distributions. The top holdings in the portfolio comprise bonds from New York (10.3%), Florida (7.5%), Pennsylvania (7.5%), New Jersey (7.1%) and Massachusetts (5.8%). Morningstar rates the fund as having above average risk metrics. Its Sharpe ratio is 1.21 compared to the benchmark’s 1.14. Most notable about EIV is that it has excellent credit quality. Recall that the category average for bonds rated A and above is 74% and for MUB, the benchmark ETF, it’s 83%. Compare EIV: With 92% of its bond portfolio rated A or better, credit risk becomes a near insignificant factor. Finally, EIV outperformed its category in 2014 on a NAV and market price basis despite having not suffered the significant discount compression along the way that its peer funds did. Summary and My Top Choice Any of the three I’ve listed here are, in my view, worthy of a hard, close look for those exploring an investment in tax-free high-yield. My top choice would be the Eaton Vance offering, EIV, but my enthusiasm for it as top choice is somewhat tempered. On the plus side is its portfolio characteristics (credit quality, maturity and duration) which are clearly the best of the three. At

Dividend Growth Stock Overview: Aqua America, Inc.

Summary Aqua America provides water and wastewater services to 3 million customers across 8 states. The company seeks to grow through acquisitions; it completed 13 acquisitions in 2014. Aqua America has increased dividends for 22 years, and over the past 5 years, it has grown dividends at an average rate of nearly 7.6%. About Aqua America Aqua America (NYSE: WTR ) is a holding company that, through its subsidiaries, provides water and wastewater utilities to 3 million customers across 8 states. The company owns and operates over 1,440 public water systems, and 187 wastewater treatment plants and collection systems. Aqua America originated as the Springfield Water Company in 1886 when a group of Swarthmore College professors were granted a charter to supply water to residents of Springfield Township, PA. Having started in Pennsylvania, half of Aqua America’s customers are in that state with the remaining customers distributed over Illinois, Indiana, New Jersey, North Carolina, Ohio, Texas and Virginia. Aqua America’s strategic objective is to grow in the fragmented water utility industry through acquisitions. The company completed 13 acquisitions in 2014. The most recent acquisitions were the Caroline Water Company, which serves 3,000 people in Caroline County, VA; Texas H2O which serves 3,300 customers in the suburbs of the Dallas-Fort Worth metropolitan area; and the Spartan Village water and wastewater systems – serving 650 customers – from the New Jersey village government. In 2013, the last year for which full-year figures are currently available, Aqua America’s income was $221.3 million, up 12.6% from 2012; and its income per share was $1.25, up 11.6% from 2012. Aqua America’s customer base was up 1.3% to 941,000 customers. One area of concern is the company’s high level of debt. At the end of 2013, Aqua America had $1.5 billion in long-term, fixed-rate debt with an average interest rate of 5%. Another area of concern is the degree to which Aqua America’s organic income growth is dependent on rate increases granted by local and state regulatory authorities. The company is a member of the S&P Mid Cap 400 index and the S&P’s High Yield Dividend Aristocrats index, and trades under the ticker symbol WTR. Aqua America, Inc.’s Dividend and Stock Split History (click to enlarge) Aqua America has paid quarterly dividends since 1944 and increased dividends annually since 1992. Last year, Aqua America announced a dividend increase of 8.6%, from 15.2 cents to 16.5 cents per share, at the beginning of August. The stock went ex-dividend with the increased dividend in mid-August. I expect Aqua America to announce its next dividend increase in early August 2015. Aqua America has a history of moderate dividend increases, with annual dividend growth in the mid-single digit percentages. From 2009-2014, Aqua America grew its dividend from 44 cents to 63.4 cents per share, for a 5-year compounded annual dividend growth rate (CADGR) of 7.58%. Aqua America’s 10-year and 20-year CADGRs are 7.99% and 6.83%, respectively. Aqua America has split its stock eight times since 1986. In September 1986 and June 1996, Aqua America conducted 3-for-2 stock splits. This was followed by a 4-for-3 stock split in January 1998, and 5-for-4 stock splits in December 2000, December 2001, and December 2003. In December 2005, Aqua America split its stock again, this time 4-for-3. And most recently, the company split its stock 5-for-4 in September 2013. Over the 5 years ending on December 31, 2014, Aqua America stock appreciated at an annualized rate of 16.93%, from $12.22 to $26.70. This beat both the 13.0% annualized return of the S&P 500 and the 14.9% annualized return of the S&P Mid Cap 400 index during this time. Direct Purchase and Dividend Reinvestment Plans Aqua America has both direct purchase and dividend reinvestment plans. The company has created a very favorable pair of plans for investors. The company pays nearly all of the fees associated with purchasing stock, including through dividend reinvestment. There are no fees to setup an account, or to purchase stock – either directly or through dividend reinvestment. The minimum investment for new accounts is $500, either in a single purchase or in 10 monthly installments of at least $50 each. The plan permits both purchases by check or automatic debit. The most attractive feature of Aqua America’s dividend reinvestment plan is the discount. The company currently offers a 5% discount on the purchase price of shares bought through the dividend reinvestment plan. This will reduce your cost basis and is taxable, but is extremely beneficial to you as an investor. Aqua America is one of a very few companies that offers shares purchased through dividend reinvestment at a discount to the market price. Finally, when you go to sell your shares in the plan, you’ll pay a transaction fee of either $15 or $25, depending on the type of sell order you request. You’ll also pay an additional fee of 12 cents per share sold. Furthermore, if you place your sell order through a representative on the phone, you’ll pay an additional fee of $15. Helpful Links Aqua America, Inc.’s Investor Relations Website Current quote and financial summary for Aqua America, Inc. (finviz.com) Information on the direct purchase and dividend reinvestment plans for WTR

The Refined ETF Approach To Emerging Markets Consumers

Summary More investors are diversifying with overseas exposure. Why investors should take a look at consumer sectors in emerging markets. Emerging market consumer sector ETF options. Investors have heard plenty about the rise of the emerging markets consumer in recent times, a theme easily accessed by a growing number of exchange-traded funds. Emerging markets investing, including doing so with ETFs, is changing, presenting investors with opportunities to take more tactical, thematic approaches to tap into the rise of developing world consumers. With many traditional emerging markets ETFs either too concentrated in the BRIC nations, excessively exposed to state-run enterprises or both, investors should rethink how they access emerging markets consumer trends. That includes making bets on some of the least developed developing markets. “Investors should focus on buying EM consumer companies in the least developed economies, as well as those EM companies geared towards domestic demand, rather than external demand through exports. Investors should look for stocks in the discretionary sector in countries where the consumption of staples has been satisfied, but consumption of durable goods has not,” according to Emerging Global Advisors , the company behind the EGShares family of ETFs. EGShares’ ETFs include consumer-focused offerings such as the EGShares India Consumer ETF (NYSEArca: INCO ) , the EGShares Emerging Markets Consumer ETF (NYSEArca: ECON ) and the EGShares Emerging Markets Domestic Demand ETF (NYSEArca: EMDD ). ECON, which carries a four-star rating from Morningstar, is up 15.4% over the past three years, enough to easily outpace the Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO ) and the iShares MSCI Emerging Markets ETF (NYSEArca: EEM ) . The allure of ECON, one of the original dedicated emerging markets consumer ETFs, comes from its large combined weight to reform minded countries. For example, China, Mexico and India combine for over 41% of the ETF’s weight. “The new Indian government, led by Prime Minister Narendra Modi, intends to privatize state assets, increase foreign direct investment and reduce the fiscal deficit by cutting subsidies. There are also plans to deregulate the labor market and upgrade infrastructure. These improvements should unleash investment, increase efficiency, raise productivity and boost growth,” said EGShares in a whitepaper . If Modi delivers on the expected reforms, that could power INCO even higher. Often overlooked compared to other India ETFs , INCO also carries a Morningstar four-star rating. More important than that accolade is INCO’s performance. For much of the past year, India ETFs have been BRIC leaders, but INCO has shined especially bright with a gain of almost 77%. EMDD tracks the S&P Emerging Markets Domestic Demand Index, and draws from a country universe of Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Thailand, and Turkey. Though not a pure consumer ETF, EMDD does allocate a combined 56.6% of its weight to staples and discretionary sectors. The weight to those sectors is important because consumer sectors have been key contributors to emerging markets earnings growth in recent years. “Emerging market consumer sectors have delivered higher earnings growth in four of the last seven years when compared to the broader emerging market equity index. Although earnings have disappointed over the last two years, we believe this should be a temporary relapse since consensus earnings are forecast to rebound in 2014 and 2015. Based on these estimates, EGA calculates that the EM consumer sectors would deliver earnings growth of 4.1% in 2014 and 16.2% in 2015, respectively, surpassing the rates of growth offered by the overall emerging markets index (3.8% in 2014 and 9.0% in 2015),” according to EGShares. South Africa, China and Mexico combine for over 55% of EMDD’s country weight. The ETF’s index has an impressive dividend yield of almost 3.4%. EM Consumer Fundamentals Table Courtesy: Emerging Global Advisors Tom Lydon’s clients own shares of EEM.