Muni Bond Funds Look More Expensive but Demand's Still Strong

With paltry yields on savings accounts, money markets, CDs, and U.S. government debt, investors have flocked to corporate and municipal debt en masse this year in search of higher yields and closed-end municipal bond funds have been no exception.

Now, however, a lot of the bargains are gone and in our MuniFundInvestor.com newsletter, the number of recommended funds with a buy signal has dropped dramatically. What follows is a current snapshot of the closed-end municipal bond fund landscape.

Currently, closed-end national municipal bond funds are delivering yields ranging from 3.5% up to 9.1% depending on the quality of their holdings and the amount of leverage they employ. More than three quarters of all the closed-end national municipal bond funds employ leverage and the amount of leverage ranges from 25%-50% depending on the fund.

Leverage (and the higher yield it delivers) is one of the key reasons for investors to choose a closed-end fund over the iShares S&P National Municipal Bond ETF (MUB), mutual funds, or holding individual bonds. With MUB currently yielding 3.69%, it yields less than all but one of its closed-end cousins. The average yield of the 25 unleveraged closed-end national municipal bond funds is 5.78% and the average for the leveraged ones is over a full percentage point higher at 6.86%.

There over 107 closed-end national municipal bond funds to choose from and back in November-December of last year, most traded at discounts to net asset value in excess of 10%. Granted discounts in that time frame were unusually high, but they have shrunk dramatically as investors have scoured the landscape for yield.

As of 8/19/09, only 70 of these funds traded at a discount to net asset value and the average discount is now just -1%, which is unusually small, meaning that, at least compared to their long-term history, these funds are now expensive (find the discounts to NAV at etfconnect.com).

Still, with government debt yields so low, it would not be surprising to see this situation continue until even more of these funds trade at par.

Comments

[muniguy:]

Why all this focus on yield? Despite the fact that yield is a very poor indicator of actual return the term is still bantered about as being equal to return. Yield is a good indicator of risk, namely credit risk, and should be used as such. Investors weigh investment options based on their potential for future return.

Many investors balked at the low yields of U.S. Treasuries at the beginning of 2008 versus relativley high corporate (high-grade and high-yield) yields. They made an investment decision based on yield and equated yield to return. Those investors missed high double digit returns from U.S. Treasuries and accepted low to negative Corporate bond returns...Yield is NOT return! It was a good example of credit risk...

I would caution investors to consider where true return (income, realized gains or losses) is generated and to understand exactly how return is generated. Using yield as a measure of an assets return potential is likely the main risk that they will face.

Aug 23 08:59 AM

[Joe Eqcome:]

Garret

I’ve been looking at CEF distributions based on net investment income. I was surprised to learn that a significant segment of muni CEFs have increased their dividends in the past 12 months.

I’m not sure whether this is a function of a change in the composition or cost of leverage—some of the ARPS have some pretty low default rates. Or whether it is a function of a temporary suspension of the distribution of the underlying munis that have been reinstated? Or, lastly, the net investment income characterization of the distribution may be temporary and might be changed at fiscal year end.

I guess the point is that distributions have risen for the muni CEFs which can have an impact on the distribution yield expectation and capital appreciation of the underlying shares.

Whether the distribution increases will continue is subject to additional study.

Joe Eqcome

Aug 24 11:42 AM

[Garrett Bea...:]

Hi Joe, one of the attributes that we actively monitor in our newsletter are the funds that have increased their dividend over the prior 12-month period. Last time I checked (a couple of months ago) 21 out of the 107 that we actively follow has increased their dividend. We have found a fairly strong and not surprising relationship between the increase in dividends and the capital appreciation of the funds.


On Aug 24 11:42 AM Joe Eqcome wrote:

> Garret
>
> I’ve been looking at CEF distributions based on net investment income.
> I was surprised to learn that a significant segment of muni CEFs
> have increased their dividends in the past 12 months.
>
> I’m not sure whether this is a function of a change in the composition
> or cost of leverage—some of the ARPS have some pretty low default
> rates. Or whether it is a function of a temporary suspension of the
> distribution of the underlying munis that have been reinstated? Or,
> lastly, the net investment income characterization of the distribution
> may be temporary and might be changed at fiscal year end.
>
> I guess the point is that distributions have risen for the muni CEFs
> which can have an impact on the distribution yield expectation and
> capital appreciation of the underlying shares.
>
> Whether the distribution increases will continue is subject to additional
> study.
>
> Joe Eqcome

Aug 25 11:47 AM