A Good Investment Opportunity For Phil Mickelson

Aug.13.13 | About: Invesco California (VCV)

Back in January, Phil Mickelson, who normally earns around $60 million a year, complained about the high tax rates he had to pay as a California resident:

"If you add up all the federal and you look at the disability and the unemployment and the Social Security and the state, my tax rate's 62, 63 percent," Mickelson said. "So I've got to make some decisions on what I'm going to do"

The calculations for the top marginal tax rate can get quite complex. Two professors (Gerald Prante and Austin John) have published a paper where they compute the top marginal effective tax rates (e.g. METR) for each of the fifty states for 2013 on wages, interest, dividends, capital gains and business income.

According to their calculations, Phil's 62 percent estimate is too high, since adding up the tax rates without making adjustments is incorrect. The METR numbers computed in their paper take into account the many deductions in the tax code, including the federal deductibility for state and local taxes. Some states use federal itemized deductions in calculating state income tax liability, which means that one's own state deduction paid, is effectively deductible against itself but in a different year!

Here is a summary of the 2013 changes that affect taxable income:

  • The top ordinary tax rate has increased from 35% to 39.6%
  • The temporary 2-percentage point reduction in employee Social Security taxes has expired after being in place for two years
  • The phase-outs of personal exemptions and itemized deductions (the "Pease" provision) for taxpayers earning over $250,000 have returned.
  • A new 3.8% tax on unearned income for taxpayers with income greater than $200,000 (singles) and $250,000 (married) will take effect.
  • A new 0.9% tax on Medicare wages on high income taxpayers will take effect

There are now several places where the top METR on taxable income is fifty percent or greater using the methodology described in the paper:

Top Marginal Effective Tax Rate >= 50%



New York City






Washington DC


New Jersey




Click to enlarge

Over the last three months, there has been a big sell-off in muni bond CEF prices caused by the higher Treasury rates and the psychological effect of the Detroit bankruptcy. But there are several reasons to be more optimistic:

- Long term interest rates have moved much higher based on the consensus view that the Fed would begin tapering bond purchases in September. It now looks like the Fed tapering may not begin until the end of the year and may occur at a very slow pace.

- The market has likely over-reacted to the Detroit bankruptcy. This week, California sold $5.5 billion of notes putting it on pace for the least short-term borrowing in five years, and California is on the brink of its best credit rating since 2001. Governor Jerry Brown forecast an $817 million surplus this year.

- Discounts to NAV for the muni bond CEFs have risen to the highest levels since the credit crisis of 2008.

The Invesco VK California Value Muni Fund (NYSE:VCV) is a leveraged municipal bond fund that seeks current income exempt from Federal and California income tax, and appears to be a great investment now for someone like Phil Mickelson who lives in California and has high taxable income.

Factor #1a: What is the distribution rate?

VCV currently has a high distribution yield of 7.31%. It pays a regular monthly dividend of $0.0660 per share or an annual distribution of $0.792.

Factor #1b: What is the taxable equivalent yield?

The taxable equivalent yield for a municipal bond investment is the pre-tax yield that a taxable bond would need to possess so that its yield is equal to a tax-free municipal bond. This is the fairest way to compare the yield of a municipal bond investment to a taxable bond investment.

Taxable Equivalent Yield= Tax Free Yield / (1 - tax rate)

For an investor in the top income tax bracket, like Phil Mickelson, we use the METR tax rate of 52.6% for VCV.

VCV Taxable Equivalent Yield= 7.31%/(1 - 0.526) = 15.42%!!

Factor #2: What is the likelihood the fund can raise its monthly dividend?

To determine this, I look at the Average Earnings/Current Dividend Ratio. This ratio tells you whether or not a fund is earning its current dividend. If the value is well above 100%, it means the fund can easily afford to raise its distribution rate.

For VCV, the average earnings as of May, 2013 was $0.0661, so the latest Average Earnings/Current Dividend ratio= 100.15%. The earnings yield is 7.33%.

This factor is neutral to slightly positive, since VCV did earn its last distribution. There is also a small positive value for "Undistributed Net Investment Income" or UNII Balance of +0.0161 which is a small reserve to help cover future monthly shortfalls if/when they occur.

Factor #3: What is the Expense Ratio?

I look at the Baseline expense ratio which does not include leverage costs. VCV has a baseline expense ratio of 1.03% which is about average.

Factor #4: What is the discount to NAV?

VCV is currently selling at a -10.13% discount to NAV. The 52 week average discount is -1.83%. The one year Z statistic is -2.16. So on a one year basis, the discount is more than two standard deviations below average. Overall, this factor is a very strong positive for VCV!

Factor #5: How much leverage is used, and what is the borrowing cost?

As of December 2013, VCV used 37% effective leverage including ARP financing and TOB assets. This is the asset breakdown in January 2012-

Total Assets $1022.95 Million

Muni Pfd Assets $188.3 Million

TOB Assets $189.67 Million

VCV no longer uses ARP financing. Its average leverage cost is 0.92% on inverse floaters and 1.20% on its muni term preferreds. This is a slight negative compared to some other funds with access to lower ARP borrowing costs.

That said, the interest rates on the muni term preferreds are locked in for several years (2015/2016) which may eventually benefit the fund if short term interest rates rise sooner and more dramatically than expected.

Factor #6: What is the AMT exposure?

As of 05/31/2013, VCV had 7.49% in bonds subject to AMT.

Factor #7: What is the credit quality?

I look at the breakdown of AAA, AA, A, BBB, Below BBB & Unrated.

This is the ratings breakdown for VCV as of 5/31/2013:



Pre-refunded 4.52%











NR/ Other


Click to enlarge

VCV is a medium risk fund with an average credit rating around A.

Factor #8: What is the interest rate exposure?

VCV has an option-adjusted duration of 10.53. This is fairly high, so I recommend adding other lower duration or senior loan funds in combination with VCV, so that your overall portfolio duration would be reduced.

Factor #9: What is the call exposure?

Here is a table with the call dates for bonds in VCV:

2013 9.08%
2014 2.92%
2015 4.54%
2016 3.33%
2017 7.79%
2018 9.80%
2019 12.12%
2020 10.63%
> 2020 28.41%
Non-Callable 11.40%
Click to enlarge

VCV has moderate call risk over the next few years in case interest rates reverse direction and start to fall. The average coupon rate of its bonds is 5.40%.

Factor #10: What are its holdings in Puerto Rico bonds?



Puerto Rico


Virgin Islands




Click to enlarge

Exposure to Puerto Rico which has higher risk is only around 2%.

Factor #11: How good is the trading liquidity?

VCV has an average daily volume of 140,000 shares, and an average daily dollar volume of $1.51 million. VCV is more liquid than most of the other state muni bond CEFs, but some care is still needed to sell larger blocks.

Factor #12: What is the sector breakdown?

VCV is well diversified. This was the sector breakdown as of May 31, 2013:

Local General Obl.




Dedicated Tax


Water/ Sewer




State General Obl.


Incremental Tax


Public Power


Higher Education




Click to enlarge

Factor #13: Fund Management

VCV is team managed. The team joined Invesco in 2010 and came from Van Kampen as part of the merger.

-Thomas Byron

-Robert Stryker, CFA

-Julius Williams

-Robert Wimmel

Based on the above factors, I am currently quite bullish on VCV based on the improving financial conditions in California, the amazingly high taxable equivalent yield (over 15%) and the high discount to net asset value (over 10% discount).

There are currently many other bargains available in the muni bond CEF space. Some of the New York muni bond CEFs also offer very attractive taxable equivalent yields, especially for NYC residents in the top tax bracket.

Disclosure: I am long VCV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.