Municipal Bonds Closed End Funds - How To Find The Best Values
Mar. 3, 2015 2:50 PM
- Municipal closed end funds offer attractive returns.
- The funds often trade below their asset value.
- A new method is presented to evaluate which funds offer the best value.
Closed end funds (CEFs) of municipal bonds are an attractive option for taxable accounts. In this article I will explain how the CEFs are priced by the market and how to choose the best one to invest in.
A publicly traded investment company that raises a fixed amount of capital through an initial public offering. The fund is then structured, listed and traded like a stock on a stock exchange.
CEFs that specialize in municipal bonds hold a portfolio of hundreds of bonds that is actively managed. Most muni CEFs are also leveraged which means that they issue debt that is also used to purchase municipal bonds.
I invest in municipal bond closed end funds for several reasons:
- Their tax equivalent yield is high reaching over 10%
- I believe that long term interest rates will remain low for many years
- I don't expect the credit worthiness of munis to worsen as a class
- They are much less risky than any other high yielding instruments (for example, the daily volatility of the major mREITs is twice that of muni CEFs)
In order to choose which of the 180 or so muni CEFs to invest in, I have developed an analysis and visualization tool. It has provided me with very interesting insights that I would like to share with you. It turns out that choosing the right fund to invest in is rather complex but definitely worth the effort.
I have set up a website where you can visualize the relationships I describe in the article yourself: http://vixcentral.com/cefexample
Let's get started by thinking about the price of the fund relative to the price of the assets it holds. Unlike regular mutual funds, CEFs can trade below their Net Asset Value. In principal, if you buy a CEF trading below NAV, you are buying bonds at less than their market value. So does that mean that we should just buy the CEF trading with the largest discount to NAV? The answer is no. Imagine two funds, call them Fund A and Fund B, holding the same exact portfolio of bonds with the same exact number of shares outstanding. The only difference between the funds is that the fees for Fund A are 0.5% per year and for Fund B they are twice that at 1% per year. Obviously, you would prefer to buy Fund A since its return would be 0.5% better per year for the same risk. So would any rational investor. Therefore, the market price of shares of Fund B would be lower than that of Fund A. Fund B would be selling at a bigger discount or less premium to NAV than fund A, but it does not make it a better deal. By itself, the discount to NAV is not a good way to determine which fund to buy. What investors care about is the actual distribution rate of the fund, in other words, the actual return on investment. In a perfect world, the price differential between shares of Fund A and Fund B would result in both investments providing the exact same return.
What factors influence discount/premium of a fund? As the example above shows, fees and expenses play an important role. Apart from the management fees, leveraged funds also incur interest expenses and expenses associated with administering debt. Expenses lower the distribution investors receive per share and investors therefore are unwilling to pay NAV for the fund and demand a discount. In fact, any factor that would reduce or enhance a fund's yield on NAV would influence the discount/premium. The other major factor influencing return on NAV is the skill of the fund managers in finding bonds with attractive yields.
Let's take a look at the discount/premium as a function of yield on NAV for all long duration national muni CEFs with leverage over 25%:
The relation is pretty obvious. In fact, if a linear regression is run, the yield on NAV explains over 80% of the variation in the discount/premium. This is rather surprising since you would think that investors would mostly care about return relative to risk. But analyzing the data shows that the Sharpe Ratio of the funds, both on their actual price fluctuations and NAV fluctuations has very little explanatory value if at all.
Investors predominantly care about the absolute returns of the funds in assigning value to them and do not take into account the return relative to the risk. I think that this may be due to two reasons. The first is that it is fairly difficult to obtain the volatility of the NAV of CEFs. The second is that since many of the bonds held by the funds are illiquid and lightly traded, investors may believe that NAV as well as fluctuations of the NAV are not reliable. What is real and reliable are the actual returns investors receive and this is what is used to value the funds. If a fund yields less than about 6.6% on NAV it will trade at a discount thus pushing
the actual return higher towards the 6.6% number.
You would expect therefore that the actual distribution rate of all funds would be very close. Though the discount/premium reduces the range of the actual distribution rate of the funds, it remains much larger than would be expected, as can be seen from the graph below.
Most funds yield between 5% and 6% on NAV. Due to their market discount relative to NAV, their actual distribution is bumped up to the 5.5% to 6.5% range. Still, why are lower yielding funds trading at higher discounts so as to bring their actual returns closer to that of the better performing funds as would be expected in an efficient market?
I think there is another factor at play which limits the discount to NAV at which funds can trade which in turn limits the ability of the returns to converge. For several reasons, the firms issuing the funds are reluctant to let the discount become too large. When the discount grows above 11% or so there is pressure on the fund managers to start purchasing their fund's shares to support the price. The following Barron's article sheds some light on this process: Nuveen closed end muni funds gain amid tender offer .
In effect, when you buy a share in a CEF, you also receive a complex put option that guarantees that the discount relative to NAV will not be too large. In the case of leveraged muni CEFs it seems that the discount for the floor is about 11% to 13% and varies between the fund managers. The graph below shows the funds of the two major issuing companies, Nuveen and BlackRock (NYSE:BLK ).
As can been seen, the lower bound for Nuveen is about 13% and for BlackRock about 10%-11%. The option investors get when they buy a CEF is a strange one. It is not a plain-vanilla put option since it is not based on the value of a share but on the relative price of the share to NAV. For example, NQI (on the bottom left of the graph), may still go down say if interest rates go up and the NQI NAV goes down, but the discount at which the share price is traded relative to the NAV will not grow larger. In order to illustrate the value of the option, let's assume that the muni CEFs NAVs are constant or are in an upward trend as has been the situation for the last year. In this case, the option is very valuable because it basically guarantees that NQI will only go up in price. Since the NAV is either constant or rising, and the discount cannot grow, NQI's market price will have to rise as its NAV rises. NQI's distribution rate is about 5% which is tax equivalent to about a 7.5% return. That is a nice return with no risk of any capital depreciation.
When a fund trades at less of a discount or at a premium, the value of the option goes down since there is more leeway for the discount to grow and less incentive for the fund managers to "close the gap" by repurchasing shares.
To summarize, each share of the CEF includes an implied option that the discount to NAV cannot go over a certain percentage threshold. The closer to the threshold that the share trades, the more valuable the option is. Investors value CEFs based on two factors a) return on NAV and b) their price distance from the discount threshold. Currently, to be traded with no discount, a fund needs to return about 6.6% on NAV. This number can be gleaned from the actual market prices. For every percentage point below 6.6% that a fund returns on NAV, the market price will reflect on average a discount of about 6.5% till the discount threshold is reached. The discount threshold varies between the fund issuing companies. The two factors work in opposite directions. As one grows in value, the other's value diminishes.
Let' examine again the relationship between yield on NAV and discount/premium. This time we add the regression line to the graph.
The regression line is an estimate of what the discount rate should be relative to the yield on NAV. Funds below the line are selling at a larger discount than they should be and are underpriced relative to other funds. Funds above the line are overpriced relative to other funds. In this set of data from January 16, 2015 the best value is VGM. It is trading about 5% below its fair value according to my analysis. I use the same procedure to also select single state funds. In my case, those of New Jersey though the effort is worthwhile also for New York and California funds.
Selecting the right fund to invest in is not simple. But once all the funds are analyzed together, a picture emerges of how the market values the funds and which funds offer more value. As a word of caution, the bid ask spread on CEFs is not always tight so be patient and use limit orders.
Disclosure: The author is long VGM.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.