This is the third of a series of articles on specific municipal bond closed-end funds (see first article here, second article here). I have selected a national fund today with a distribution yield above 8%.
The muni bond funds in the 8+% tier are riskier than the lower yielding funds, but several of them contain mainly investment grade bonds, and have much lower risk than equivalent high yield corporate bond funds.
All of the municipal bond CEFs with distribution yields above 8% currently trade at a premium over net asset value. For this report, I’ve selected the Invesco VK Investment Grade Municipals Fund (VGM). It is a leveraged fund with an average credit quality in the A range, decent trading liquidity and medium AMT percentage.
I will be discussing the same 14 factors that I used to evaluate other municipal bond closed-end funds. For more background information on these factors, refer to my first report on NPM.
Factor #1: What is the distribution rate?
VGM currently has a distribution yield of 8.19%. For someone in the 35% marginal tax bracket this is a taxable equivalent yield of 12.60%! It pays a regular monthly dividend of $0.088 per share or an annual distribution of $1.056.
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 VGM, the average earnings over the last three months is $0.0981, so the Average Earnings/Current Dividend ratio= 110.5%. This is quite favorable.
There is also a healthy positive value for “Undistributed Net Investment Income per share” or UNII of +0.5140, which means that VGM has more than six months' monthly interest in reserve to cover any future monthly shortfalls.
Factor #3: What is the Expense Ratio?
I look at the Baseline expense ratio which does not include leverage costs. VGM has a baseline expense ratio of 1.03% which is quite reasonable. Anything over 1.5% is a big negative.
Factor #4: What is the discount to NAV?
VGM is currently selling at a 1.26% premium above NAV. This is slightly below the 6 month average premium of 2.53%. The one year Z statistic is -0.36. So over the last one year, the premium is about half a standard deviation less than usual. Overall, this factor is probably a neutral for VGM, but I would still prefer buying it at a discount.
Factor #5: How much leverage is used, and what is the preferred share asset coverage?
VGM currently uses 42.96% effective leverage including tender option bonds. The preferred asset coverage ratio is currently 361% which provides an adequate margin of safety. I would be concerned if this ratio dipped below 225%.
Factor #6: What is the AMT exposure?
VGM has an AMT percentage of 13.43%. This is a little above average. I consider 10% AMT to be about average, and anything over 20% is high. This factor is somewhat negative for VGM for those investors that are affected by AMT.
Factor #7: What is the credit quality?
I look at the breakdown of AAA, AA, A, BBB, Below BBB & Unrated. Within the AAA category, a higher percentage of pre-refunded bonds is a positive, because these bonds are effectively backed by the US government.
This is the ratings breakdown for VGM:
BB & Below
Considering its distribution yield, the VGM portfolio has a pretty good average credit rating of around A. I like to see the lowest rating category below 10%, and VGM just barely qualifies.
Factor #8: What is the interest rate exposure?
VGM has an effective duration (adjusted for leverage) of 18.06 years. This is well above average, and is one reason why VGM can earn such high dividends. I prefer a lower portfolio duration below ten years, but VGM can be combined with other lower duration funds to accomplish this objective.
Factor #9: What is the call exposure?
Here is a table with the call dates for bonds in VGM:
VGM has relatively low call risk over the next six years. The average price of its bonds is 100.69.
Factor #10: For a national fund, what is the breakdown by state?
The top five states are:
The Illinois percentage is well below 10%, and VGM has good diversification by state.
Factor #11: How good is the trading liquidity?
VGM has a three month average daily volume of 178,000 shares, and an average dollar volume of $2.29 million. It would be relatively easy to buy $50,000 worth of VGM in one day.
Factor #12: What percent of the portfolio is in Housing Multi-Family bonds?
Given the shaky housing market, I like to avoid funds where the Housing Multi-Family sector is above 10%.
VGM does not have exposure to housing, but it does have 17% in hospital bonds and 9.54% in the IDR/PCR (IDR= Industrial Development Revenue/PCR= Pollution Control Revenue) sector which can include stadiums, airports and convention centers and are somewhat higher risk. But for a fund in the 8% yield tier, VGM appears to have acceptable credit risk.
Factor #13: Fund Management
VGM is team managed. The senior portfolio manager is Thomas Byron. He was with Van Kampen since 1981 and joined Invesco in 2010. Robert Stryker, CFA joined Morgan Stanley in 1994 and also worked at Van Kampen before joining Invesco. Robert Wimmel has worked at Kemper and Van Kampen and also joined Inveso in 2010.
Factor #14: Other Analyst Coverage
VGM is covered by the Merrill Lynch closed-end fund team and is rated as a Neutral.
Based on the above 14 factors, I believe that VGM is currently a good speculative holding as part of a diversified municipal bond portfolio, especially if you can buy it at a discount to NAV.
Disclosure: I am long NPM.
Disclosure: I am long NPM.