Closed-end municipal bond funds currently appear attractive for the following reasons:
- The spread between municipal bonds and treasuries are at historic levels since the ‘50s;
- The potential for an increase in federal income taxes would makes muni bonds more valuable;
- 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.