The Managed Duration Investment Grade Municipal Fund (NYSE:MZF) is a closed-end fund (CEF) that invests in high-quality municipals and uses leverage to enhance returns. The CEF currently trades at a >9% discount to NAV and yields 6.6%. The fund's objective is high current income exempt from regular Federal income tax, while seeking to protect the value of the fund's assets from interest rate risk. In 2013, 99.4% of the fund's total distributions were from tax-exempt income, meaning for individuals in the 35% tax bracket, MZF provides a ~10% tax-equivalent yield. See graph below for a summary (Source: Cutwater website).
Cutwater Asset Management ("Cutwater"), a subsidiary of MBIA, is the portfolio manager on the Managed Duration Investment Grade Municipal Fund. Cutwater is a fixed income specialist firm, managing $24 billion in AUM for institutions and retail investors. Cutwater's investment philosophy is based on several tenets, including (Source: Cutwater Asset Management website):
- Employ a counter-cyclical approach to capital allocation, which means adding risk to the portfolio when the margin of safety is high and de-risking when the margin of safety is low. Consider capital allocation in light of the entire business cycle.
- Focusing on spread sectors, where inefficiencies are greatest, including non-index sectors.
- A separation of fundamental credit research from relative value analysis.
- Strong emphasis on risk management.
Cutwater has a deep bench of investment talent and a longstanding senior management team that has been built out progressively since 1994. The firm leverages its asset scale, technology, and portfolio management expertise across ~20 total return strategies, as well as the management of other structured and customized strategies.
The PM team is supported by Cutwater's team of credit analysts for evaluating the credit quality of individual muni sectors and issues for the portfolio. Over the years, Cutwater has developed proprietary quantitative models to help evaluate the risk of individual securities, as well as the entire portfolio. This analysis is supplemented by the qualitative judgment of the PM team, with the goal of adding incremental yield to the portfolio while maintaining the desired level of credit risk. MZF's portfolio has an average credit quality of "A" and should remain in that range.
The portfolio managers formerly used interest rate swaps to manage the duration of the fund, but ceased using that strategy. Instead, the fund's duration is managed through bond selection. The fund has sought to differentiate itself from other bond funds through its focus on total return as well as yield. The primary strategy the fund has used to accomplish this goal is through investing in high-coupon callable bonds, which limits duration risk and should perform well if there is a moderate rise in interest rates. Analyzing the most recent N-Q, it is extremely rare to find a bond with a first call provision that extends beyond 2023 (9 years out), and most bonds have first call provisions that are much closer. In addition, the firm has also been among the first muni funds to invest in the relatively new fixed-to-floating structure, which also caps duration much shorter than the term to maturity.
Like many municipal CEFs, MZF was sold off hard in 2013. The fund sunk from a near-8% premium to NAV in 2H 2012 to a near-12% price discount in mid-2013. In less than 12 months, the fund experienced a ~20% price decline due to a large fluctuation about the NAV. The simultaneous decline in the fund's NAV was far less severe. 2013 marked the second year MZF's NAV return actually declined (-7.1%) in the history of the fund. 2008 was the only other year MZF actually suffered a negative NAV performance (-22.7%), and this was followed by a huge year in 2009, when the fund's NAV surged 41.7%. The volatility in the underlying NAV is usually much less than the fund's trading volatility in the secondary market, and CEFs frequently over-correct with wide swings above and below NAV depending on whether the underlying asset class is in favor. Experienced CEF investors recognize attractive opportunities to put cash to work (e.g. high risk premiums; wide discount to NAV) and when to take chips off the table (e.g. low risk premiums; CEF premium to NAV). While prices are off their lows, now is still a good time to put cash to work.
Sources of Return
Tax-Advantaged Income: MZF is currently paying a 6.6% distribution rate. This amounts to a tax-equivalent yield of ~10% (assuming a 35% tax bracket).
Discount to NAV: is likely to tighten, now that tax-loss selling has subsided. A return to NAV should result in a ~9% return due to capital appreciation. The 3-year average premium/(discount) to NAV is -0.8%, so there is not a good reason to argue against an eventual return to NAV (Source: Bloomberg).
In addition, the Fund had a capital loss carry-forward of $5.64MM, as of its last annual report (7/31/13). Assuming standard tax rates, this would probably amount to roughly $1.5MM in value that is not currently recognized in the NAV. Based on economic value, the discount to NAV is likely closer to ~11%. At the last N-Q filing (10/31/14), the Fund has $2.2MM in net unrealized gains and $6.7MM in gross unrealized gains.
Historical discount: Municipals are not overly cheap, but if muni yields tighten back to pre-2008 trading ranges vs. Treasuries in the coming months, there is relative value to be picked up. While a very imperfect measure of the entire municipal asset class, the AAA Muni Yield to 10-year US Treasury ratio (94.6%) is a good directional indicator of how expensive the highest-quality munis are relative to Treasury yields (Source: Bloomberg). The simplified takeaway is that high-quality munis still provide good relative value for taxable investors, especially those in a high tax bracket, and could experience price appreciation if risk premiums normalize to their historical level.
Sources of Risk
Interest rate risk: In an extreme case, the yield curve could shift up 100-150 bps over the next couple years. At a leverage-adjusted duration of ~7.7, this could hit MZF's NAV by 7.7%-11.5%. Note: I called Guggenheim's CEF desk and confirmed that this ~7.7 duration measure included the effects of leverage. They also confirmed that while Guggenheim had been using interest rate swaps in the portfolio previously to hedge interest rate risk, none were being used currently.
Mitigating factor: The CEF already trades at a discount to NAV of over 9%, so much of this risk is already priced in. In addition, the muni "A"-rated yield curve is already at a historically relative "wide" spread vs. the U.S. Treasury curve, due to concerns over the creditworthiness of many municipal issues, recent events in Detroit and Puerto Rico, and concerns over changing tax legislation. Anyone can argue over the appropriate risk premium that should be embedded in munis, but history would suggest this is a good time to be buying.
Credit risk: 3% of MZF's portfolio is non-investment grade (BB, B, and non-rated) and 28% of the portfolio is rated BBB. Investors can peruse the latest N-Q to gain a good understanding of the Fund's holdings. Potential concerns include a 2% allocation to Puerto Rico and a 5.1% allocation to Michigan.
Mitigating factor: The overwhelming majority of the Fund's debt is investment-grade, with an average rating quality of "A". Of the potential concerns above, only a single Puerto Rican bond ($0.74MM) appears to be trading at a sizeable discount to its face value ($0.74 on the dollar) and is rated BB+. All other Puerto Rican and Michigan bonds are still rated investment-grade and trade reasonable close to par (i.e. don't appear to be distressed). The three Detroit bonds in the portfolio are insured by Assured Guaranty Municipal Corporation, and are trading at a premium to par.
Leverage: MZF uses 42% leverage, notably high for a CEF. MZF has historically employed this level of leverage, and is unlikely to alter this structure going forward.
Mitigating factor: The structure of the leverage is very important in evaluating CEFs, and this is especially true of MZF. At the creation of the Fund, MZF issued two Series (M7 and W28) of Auction Market Preferred Shares (AMPS) - 1,389 shares each - redeemable at $25,000 per share plus accumulated unpaid dividends. In February 2008, the broad auction-rate preferred securities market failed, and has experienced disruption since then, including the Fund's AMPS.
Provisions in the AMPS offering documents established a max rate if the auction failed. The rate for the Fund's AMPS is the greater of 1.10% + S&P Weekly High Grade Index, or 110% times the same index. The Index was later replaced with the S&P Municipal Bond 7-Day High Grade Rate Index. This has resulted in a cost of leverage of 1.25%-1.6% (Source: MZF, Annual report, 7/31/13). While this market disruption was unfortunate for the holders of AMPS securities, it has resulted in a low cost of borrowing for MZF.
Currently, there is an attractive opportunity to buy busted municipal CEFs and lever their returns by shorting Treasuries. There are multiple ways to do this, but one of the simplest is to just short a Treasury ETF, such as the ProShares Ultra 7-10 Year Treasury ETF (NYSEARCA:UST). This ETF is designed to double the daily return of the underlying Treasury index, and uses derivatives extensively to maintain the targeted exposure. This ETF was designed as trading instrument - not to produce income distributions. The underlying collateral will likely lose value in proportion to the Fund's leverage and the volatility in the underlying assets. The annualized volatility rate over last five years has been ~8%. The chart below from UST's annual prospectus does not reflect management expenses (99 bps per year) or the cost of leverage.
A good proxy for the underlying assets in UST is the iShares 7-10 Year Treasury ETF (NYSEARCA:IEF). For IEF, the weighted average maturity is 8.3 years and effective duration is 7.5. YTM is 2.4%. Because UST is 2x leveraged, this ETF's effective duration is doubled to ~15. Ignoring the costs of leverage and volatility, but including the given costs of managing UST, the expected return - barring any shifts in the yield curve - should be under 4%.
Taking a long/short position of 150/50 in MZF and UST initially leads to the following return profile, if rates stay constant. Again, these are very round numbers. This position effectively lowers the effective duration an investor is exposed to, while also enhancing the return. Any spread tightening or a return in pricing to NAV is a bonus. Note that the primary beneficiaries of such a strategy are investors in the highest tax bracket, with assets located in a taxable account. Holding the interest rate spreads constant, this strategy should generate a ~13% tax-equivalent yield, with the added tax benefit of losses from the short Treasury position to offset capital gains in the likely event MZF's discount to NAV narrows. If the discount to NAV closes within 2 years and muni spreads tighten, ~15% tax-equivalent annual returns on this position are very possible over this period.
Obviously, there are a wide range of potential outcomes when employing such a strategy. A negative movement in municipal rates vs. Treasuries creates the greatest potential for loss on this position.
Balanced Portfolio Position
Another alternative for investors with constraints against short selling would be to create a balanced portfolio containing a 50:50 allocation to MZF and a Senior Floating Rate CEF. To keep things simple, we can illustrate with the First Trust Senior Floating Rate Income Fund II (NYSE:FCT). In the current environment of low credit stress, FCT should be able to deliver levered returns of ~6%. The Fund currently has a distribution rate of 6.4%, and is trading at a ~5% discount to NAV. The distribution level and NAV will vary based on rates, thus, duration or interest rate risk is negligible. Higher rates should enable higher distributions and a higher NAV, and vice-versa.
The end result is a portfolio that resembles the rate risk of a "barbell" bond portfolio - but with higher potential returns. This strategy makes a lot of sense given the current steepness of the yield curve, and should result in lower duration/interest rate risk, while adding credit risk.
Bottom line: there is no free lunch in this era of low rates - some would debate if lunch is even an option - but it pays to examine the less-efficient areas of the fixed income market.