CEF Muni Price Relationship with Muni Spread Highlights Current Wide Divergence

Closed-end municipal bond funds currently appear attractive for the following reasons:

1. The spread between municipal bonds and treasuries are at historic levels since the ‘50s;
2. The potential for an increase in federal income taxes would makes muni bonds more valuable;
3. The recent divergence in muni spreads and CEF muni prices creates an enhanced return. 

Muni vs. Treasury Spreads: The chart below demonstrates the historical spread between a 20 year muni bond and a 10 year Treasury bond. (The 10 year Treasury bond was employed as the  federal government stop issuing 20 year Treasuries from the late ’80’s to the early ‘90s). Currently, Muni bonds are yielding more than comparable Treasuries despite their tax-exempt advantage.

click to enlarge images

CEF Munis Diverge with Spreads: The second chart shows the relationship between the average monthly indexed share price changes of three of the largest closed-end municipal bond funds versus the 20 year muni/20 year Treasury spread.

The elliptical area at the right of the chart show the recent divergence between the muni spread “spike” and the collapse of the indexed average prices of three of the larger, long operating CEF muni bond funds.

Process: I screened my universe of 148 CEF muni bond funds (national and single state) for those funds that were in continuous operation for at least 20 years, currently having more than $500 million in total assets and having premiums or discounts below their historical average premium/discount (See table below). I calculated their monthly price change and indexed it to October 1993 and then averaged the indices to create the “Muni Avg Price Index” used in the graph above.

Caveats: The prices of the muni bonds have declined precipitously and most of the closed-end muni bond funds employ leverage. Due to regulatory leverage ratio limitations based on the NAV of a CEF, a CEF may have to reduce its leverage or stop paying a dividend if it is not in compliance with such regulatory ratios. This is a risk unique to leveraged closed-end funds.

Secondly, the unique nature of this current credit crisis is deeper and wider than anyone anticipated and thus weakening municipalities’ credit ratings. This may be a secular as opposed to a cyclical phenomenon. However, assuming that this is a cyclical phenomenon, closed-end municipal bond funds look very attractive at theses prices.

Disclosure: none

Comments

[richmcn:]

the nav's plunged on many cef's in october, but it was hard to tell in real time whether it was selling of the portfolio into a declining market to pare down leverage or mark to market

2008 Nov 08 11:32 AM

[bsharvy:]

What kind of munis do the CEFs hold? General oblifgation, insured, etc.?

2008 Nov 08 05:15 PM

[Robert_A:]

All sorts, some funds only hold insured or high-rated issues, some hold riskier higher yielding or unrated issues -- your choice. etfconnect.com lists the top holdings of many CEFs along with premium/discount history, and lots of other useful info. Also check the Morningstar ratings for risk-adjusted return. One thing I find intriguing is that typically a fund will have a high percentage (as much as 35-40 %) of its holdings in just a dozen issues. Looking at their long term history, now seems like a very good time to buy, but of course many states/municipalities are or will be affected by the current crisis. You can trade these funds on their fluctuations or as buy and hold for the bond income. BTW, a few funds (CEV, NCL for example) have rebounded as much as 50% since their lows October 10 (an extremely unusual day for all equities). I'm sorry I didn't double up then, although I did increase my beaten up holdings. Looking forward, the discounts have narrowed significantly but I think there are still some good values in this sector for the longer term.


On Nov 08 05:15 PM bsharvy wrote:

> What kind of munis do the CEFs hold? General oblifgation, insured,
> etc.?

2008 Nov 08 08:16 PM