Opportunities for Gains in 2009: CEF Year-End Muni Discounts

Conclusion: There has been a historical inverse relationship between a closed end fund’s [CEF] beginning year discount and its year-end price change, i.e., the greater a CEF’s discount at the beginning of the year the greater the relative positive price change at year-end relative to other CEFs. This relationship proved uniquely strong for the Muni Sub-Index in 2008. As we prepare to embark into 2009, here are 5 Muni CEFs in the Muni Sub-Index with the greatest discounts at the end of 2008: MHN, MUJ, VPV, MYN and MUC (see summary table at end). To paraphrase Mark Twain, “History may not repeat itself, but it sure does rhyme.”

The muni markets may also benefit from the stabilization in the credit markets as well as the federal fiscal stimulus plan(s) that may include supporting state and local governments’ debt either through a federal lending facility or government guarantee programs for municipal debt. This would likely narrow the yield spread between munis and treasuries from its current historic highs. Such a narrowing of spreads could lead to a significant upward revaluation of the municipal securities.

click to enlarge

Beginning Year Discounts Vs Year-End Price Changes: The first table above illustrates the premium/discount for the CEFs comprising the Muni Sub-Index at the beginning of 2008 (year-end 2007) with their relative price changes at year-end. Below that table is a scatter diagram of the data. As the chart demonstrates there appears to be a visible relationship between the two variables. (The R^2 for the Muni Sub Index is 0.3753; approximately 38% of the price change can be associated with the level of the discount.) This is in contrast to the R^2 of the Aggregate Index of 130 CEFs comprising the Index which was minuscule for 2008; the relationship appeared almost random.

Deep Discount Muni CEFs: Below is a list of the top 5 heaviest discounted Muni CEFs at the end of 2008 in the Muni Sub-Index. The historic spread in the muni markets may narrow as the credit markets stabilize and the federal government fiscal policy may facilitate the support of municipal debt markets. Keep in mind that the muni CEFs in the chart below are all leveraged with auction rate preferred shares that are subject to regulatory leverage requirements which if breached could lead to a temporary suspension of the dividends.

Disclosure: Joe Eqcome is long MHN.

Comments

[Scott F:]

Interesting finding but not statistically robust. You really need to take random samples of the funds and the sectors and see how reliable this has been over the years. Then you'll have far more statistical confidence that 38% or any % is significantly and causally correlated with year-end. Also, there are macro fundamentals that this ignores. These are largely New York and CA munis which are at high discounts. This makes sense as they have vastly over-leveraged their confederal debt. With so much debt and more growing though mutual financial crises in NY and CA, both are going to have to go to the debt market, cap in hand, and end up paying a lot more for their muni debt. The lower-yielding munis these funds hold are going to get killed, and as all these funds are leveraged, the carnage will be amplified, maybe by as much as the entire discount. Compare these to state munis that have no leverage, and it will give you a better handle on how the market is pricing this risk.

Jan 13 12:18 PM

[claudio.lan...:]

First of all why would an investor buy say MUC CEF with an expense ratio of 1.58% bringing the yield down to below 4% when ETFs such as PWZ with an expense ratio of .28% and a yield of 5.41%. This was an article better left unpublished.

Jan 14 09:02 AM

[Joe Eqcome:]

Claudio.lane-

First of all, your comments are completely off the mark. This is not an article comparing muni CEFs versus muni ETFs.

Secondly, it appears you have a basic misunderstanding of the relationship between the management fee and stock’s distribution yield. MUC’s current yield is approximately 5.98% versus the 5.41% you quoted for PWZ. The only way you could have arrived at a 4% yield for MUC is to have subtracted the management fee from the stock’s annualized distribution yield. The management fee is an expense that is deducted prior to calculation of investment income which is the basis of the shareholders’ distribution. Consequently, MUC’s high management fee is already priced into the stock’s yield.

Assuming that you did not error with respect to MUC’s yield calculation, your main argument is that the management fees and relative yields are the key investment consideration. Most seasoned equity investors look for potential total return (current yield and change in the stock price) not just distribution yield.

In your comparison you stated that PWZ, an ETF, generates a yield of 5.14% on its stock price and has a management fee of .28%. (Don’t get me wrong, I like low management fee.) What you’ve overlooked is that the stock is trading at a modest premium to its NAV. In its short history (since October of 07) the average monthly premium is .42%; so, there is little potential organic appreciation resulting from gravitation of the premium/discount to the mean.

While MUC, a CEF, is paying a high management fee of 1.5%, its fee is already priced into the stock’s yield. MUC is in fact trading at a current yield of almost 6% and a stock price discount to NAV of 18.1%. In comparison, MUC’s average historical monthly discount is 5.25%. If MUC were to return to its historical discount of 5.25%, the stock would appreciate approximately 15.5%. If you tacked on the annual distribution yield of 6%, your total return would be 21.5%. Heck, it MUC’s discount were only to recover to half the distance between current and historical discount the total return would still be 13.8%. That might be better that the 5.14% total return you’re projecting for your ETF.

The concept of buying stocks below their intrinsic value is a fundamental investment principal.

Happy trails.
Joe Eqcome

Jan 14 04:24 PM

[Joe Eqcome:]

Let’s deconstruct Scott F’s comments.

“Findings not statistically robust”: In the aggregate, since 1995 there has been an inverse relationship between a CEF’s beginning year NAV and its price change that same year 12 out of 14 years. The two exceptions: 1996 and 2003. The strength of the relationship has varied from year-to-year but the relationship has endured over an extended period of time.

“There are macro fundamentals that this ignores”: The fact that states in financial stress have the greatest discounts shouldn’t surprise any investor who has watched the evening news. Like Chris Mathews says, “Tell me something I don’t know.” A preponderance of this information has already been priced into the stocks. I doubt if the federal government will bail out the NYC banks and not two of largest states with some type of guarantee program for muni debt. It’s “balls to the wall” when it comes to the Feds stabilizing the financial system.

“Compare these to state munis that have no leverage”: There are approximately 157 single state muni funds of which 145 (92%) have leverage and 12 that are unleveraged. The leveraged CEFs have a yield of 6.5% and are selling at a discount of 9.2%. This compares to unleveraged CEFs with a yield of 4.6% and a discount of 4.9%. The five deepest discounted muni CEFs mentioned have a yield of 6.35% and a discount of 15.9%.

I would be much more concerned regarding this investment decision if the leveraged CEFs were trading in line with the unleveraged ones. Investors do perceive the risks and have priced it in accordingly. The question is: is it enough? I believe investors are scared and are throwing in the “kitchen sink” when it comes to pricing perceived risk. I’m willing to average down from here.

When it comes to risk I’m reminded of the saying, “Ships are safe at harbor, but that’s not what they’re built for.”

As always, understand your risk tolerance and don’t bet scared money.

Happy trails
Joe Eqcome



On Jan 13 12:18 PM Scott F wrote:

> Interesting finding but not statistically robust. You really need
> to take random samples of the funds and the sectors and see how reliable
> this has been over the years. Then you'll have far more statistical
> confidence that 38% or any % is significantly and causally correlated
> with year-end. Also, there are macro fundamentals that this ignores.
> These are largely New York and CA munis which are at high discounts.
> This makes sense as they have vastly over-leveraged their confederal
> debt. With so much debt and more growing though mutual financial
> crises in NY and CA, both are going to have to go to the debt market,
> cap in hand, and end up paying a lot more for their muni debt. The
> lower-yielding munis these funds hold are going to get killed, and
> as all these funds are leveraged, the carnage will be amplified,
> maybe by as much as the entire discount. Compare these to state munis
> that have no leverage, and it will give you a better handle on how
> the market is pricing this risk.

Jan 14 06:26 PM

[Gruber:]

It's comments like this one that lowers the IQ of this site.
On Jan 14 09:02 AM [e-mail] wrote:

> First of all why would an investor buy say MUC CEF with an expense
> ratio of 1.58% bringing the yield down to below 4% when ETFs such
> as PWZ with an expense ratio of .28% and a yield of 5.41%. This was
> an article better left unpublished.

Jan 14 07:57 PM

[HighTower:]

This is pretty naive drool.


On Jan 13 12:18 PM Scott F wrote:

> Interesting finding but not statistically robust. You really need
> to take random samples of the funds and the sectors and see how reliable
> this has been over the years. Then you'll have far more statistical
> confidence that 38% or any % is significantly and causally correlated
> with year-end. Also, there are macro fundamentals that this ignores.
> These are largely New York and CA munis which are at high discounts.
> This makes sense as they have vastly over-leveraged their confederal
> debt. With so much debt and more growing though mutual financial
> crises in NY and CA, both are going to have to go to the debt market,
> cap in hand, and end up paying a lot more for their muni debt. The
> lower-yielding munis these funds hold are going to get killed, and
> as all these funds are leveraged, the carnage will be amplified,
> maybe by as much as the entire discount. Compare these to state munis
> that have no leverage, and it will give you a better handle on how
> the market is pricing this risk.

Jan 15 12:18 PM