The largest major grouping in the closed-end fund (CEF) universe is the municipal or tax-free bond investment objective. The group has 220 of the total 600 U.S. listed funds (36.7%) or $89.4 billion of the total $261.3 billion (34.2%) assets held by all closed-end funds. There are 103 national muni funds and 117 state specific muni funds for investors to choose. All data unless otherwise noted is from our weekly CEF Universe data service dated November 30, 2012.
While discounts in the municipal sector have been hard to come by recently, we feel the benefits of closed-end funds, the fixed capital for the investment portfolio and the use of cheap leverage, currently make municipal CEFs more attractive for many investors than the open-end, exchange-traded and individual bond holdings options in terms of both dividend yield and total return performance.
It should be noted that due to the effects of both leverage and market liquidity, investors should expect more volatility in a CEF than other investment options. One way for investors to use this to their benefit is by utilizing limit orders and to take patience and diligence entering and selecting points to purchase or sell shares in a CEF. If readers are not familiar with our firm's data points, there is a link to our data definitions page at the end of the article.
In the past year, the average CEF discount for national municipal bond funds has traded between -4% and +2% to net asset value (NAV). Though trading above NAV has been normal for many funds during the past year, the average forward indicated yield for these funds has slowed due to strong performance of the underlying bond portfolios, with the average national municipal bond CEF up almost +18% year-to-date on a total return basis through November 30, 2012. Because municipal funds have done so well for the past few years, we believe investors need to be very cautious about monitoring the fundamental data for their holdings to anticipate dividend changes as well as fluctuations to the fund's NAV performance when interest rates eventually rise.
Swapping similar funds regularly can help increase the investment allocation's performance over time, though this cannot be guaranteed. One way to do this is to sell a municipal bond fund if it trades above the peer group average discount/premium and to buy a peer fund if it trades below the peer group average disc/prm. This strategy works as long as both the NAV and the dividend rate of the replacement fund do as well as those of the original fund. Also, funds more likely to increase vs. cut a dividend can help an investor's income grow over time and potentially hedge against inflation.
One concern we have is that the typical municipal CEF has a declining trend in the UNII balance over the past year. We not only track the current amount of UNII in cents per share on the fund's balance sheet, but also the previously announced UNII figures, so that we can determine a trend.
We use 90-day correlation data to help identify how much a fund's recent price movement is due to the NAV movement vs. how much of it is due to investor's perceptions on the fund's future value or dividend levels.
Research Screening Premise:
In making the two lists of funds below, we reviewed the following data in order to try to identify the funds most likely to experience a dividend increase or decrease in the near future: undistributed net investment income (UNII), relative UNII, UNII trend, earnings coverage, earnings trend, having UNII/earnings data updated at least since 9/30/12, as well as having at least one year since the fund last announced a dividend change. We also screened for funds with liquidity above $500K a day to increase the likelihood that they were CEFs that investors might hold or could potentially purchase without moving the market price too aggressively.
Note: The funds above have a positive relative UNII cushion, however, we are concerned with these funds because the earning coverage is well below the dividend policy and they have both a UNII and earnings trend that is negative.
Predictive Data for Dividend Changes
CEFA is currently working on a research project to confirm the predictive value of UNII and earnings information for future dividend cuts and increases. While we expect it to take a few more months to have conclusive data for all CEF groups and all data, one data point is currently looking very promising.
Between September and November 2012, of the 15 dividend cuts for municipal bond funds where we have a UNII trend available, 100% had a negative UNII trend. We hope this gives investors reason to review the financial statements for their CEF holdings.
CEFA's Municipal Bond CEF Tips:
- Try to buy municipal CEFs that meet the following criteria:
- Lower than peer group average discount or premium
- Updated its UNII and Earnings data in the last 90 days
- Positive Earnings & UNII Trend
- Earnings Coverage over 100%
- NAV Performance above Peer Average
- Duration, Credit Quality and AMT% Exposure that meet your investment objectives
- Enough liquidity to meet your trading expectations
CEFA's Data Definitions - pdf
Additional disclosure: Disclosures: CEFA has client positions in MUA as of the writing of this issue. The information and statistical data contained herein have been obtained from sources that Closed-End Fund Advisors (CEFA) believes are reliable, but CEFA makes no representation or warranty as to the accuracy or completeness of any such information or data and expressly disclaims any and all liability relating to or resulting from your use of these materials. The information and data contained herein are current only as of the date(s) indicated, and CEFA has no intention, obligation, or duty to update these materials after such date(s). These materials do not constitute an offer to sell or the solicitation of an offer to buy any securities. CEFA may make decisions for its clients in certain of these securities. CEFA and/or their respective officers, employees, and affiliates may at any time hold positions in any of these securities and may from time-to-time purchase or sell such securities.