A Muni Bond CEF With a Unique Multi-Strategy Approach

| About: Eaton Vance (EXD)

This is one of a series of articles on specific municipal bond closed-end funds. In this report, I discuss a municipal bond closed-end fund with a unique multi-strategy approach - the Eaton Vance Tax-Advantaged Bond & Option Strategies Fund (NYSE:EXD).

EXD is a national fund that generates tax-advantaged current income using two different strategies:

  • The “Bond Strategy”: Invests in high quality short-term municipal bond holdings.
  • The “Options Overlay Strategy”: Invests in a rules-based Iron Condor strategy using S&P 500 index future options. Note that the options are on equities, not on municipal bonds.

By combining the two unrelated strategies, the fund seeks to provide attractive after-tax returns with low volatility and low correlation to equity and long-duration fixed income market returns. The fund expects to invest about 80% of the net assets in the “Bond Strategy”.

I will first evaluate the “Bond Strategy” using the same 14 factors that have been used to evaluate other municipal bond closed-end funds. For more background information on these factors, refer to my first report on NPM. I will then discuss the “Options Overlay” strategy.

Bond Strategy

Factor #1: What is the distribution rate?

EXD is a high quality fund and currently has a distribution yield of 10.33%. It pays quarterly dividends of $0.425 per share or an annual distribution of $1.70. This distribution yield is not directly comparable to other municipal bond closed-end funds because of the options overlay strategy that enhances the distribution yield.

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

To determine this, I normally 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. With EXD, the options overlay strategy adds significant uncertainty to how much EXD can pay out without return of capital.

For EXD, the December 2010 distribution was $0.425, but the net investment income was only $0.016, so the average earnings / current dividend ratio was only 3.8%. For fiscal year 2010, the average earnings / current dividend ratio was somewhat better at 23%, but 77% of the distributions were return of capital.

This factor is a negative for EXD. The fund board has approved a managed distribution plan to make fixed quarterly distributions regardless of earnings, so it is quite possible that the net asset value of EXD will tend to shrink over time. Currently the fund is selling at a discount to NAV, so at least the distributions help to recapture a portion of the discount every quarter.

Factor #3: What is the expense ratio?

I look at the baseline expense ratio which does not include leverage costs. EXD has a baseline expense ratio of 1.41% which is on the high side. This is a negative factor for EXD, but somewhat understandable because of the fund’s complex multi-strategy approach.

Factor #4: What is the discount to NAV?

EXD is currently selling at a -8.6% discount to NAV which compares to the 6 month average discount of -0.6%. There is no one year Z-Statistic available yet, since EXD was only launched eight months ago. This is the highest discount for EXD since it was issued, so this factor is somewhat of a positive.

Factor #5: How much leverage is used, and what is the preferred share asset coverage?

The fund has no current intention to use leverage, but may use it in the future.

Factor #6: What is the AMT exposure?

I could not find AMT information on the fund web site. Because of the high ratings of the underlying bonds, I would guess that the AMT% is very low or zero.

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 EXD:





Click to enlarge

EXD owns very high quality bonds with an average credit rating near AAA. This factor is a strong positive for EXD for investors concerned about municipal bond credit exposure.

Factor #8: What is the interest rate exposure?

NPM has an average duration of 2.6 years. This is very low and EXD has minimal interest rate risk. If the overall interest rate level rises by 1% or 100 basis points, the price of EXD’s bonds would fall by only 2.6%. The options overlay strategy also provides additional diversification. This factor is a positive for investors who are concerned about interest rate risk.

Factor #9: What is the call exposure?

The fund has not provided call risk information for their portfolio, but given the very low 2.6 year duration, this is not a big concern.

Factor #10: For a national fund, what is the breakdown by state?

The fund did not report a percentage portfolio breakdown by state. I took a look at the top portfolio holdings, and the fund seemed to be well diversified. Some of the larger holdings were from New York, Massachusetts, North Carolina and California.

Factor #11: How good is the trading liquidity?

EXD has an average daily volume of 68,400 shares, and an average dollar volume of $1.1 million. You should be able to buy $50,000 of EXD in one day fairly easily without a major impact on the price.

Factor #12: What percent of the portfolio is in housing-multifamily bonds?

I did not see any housing bonds in the portfolio.

Factor #13: Fund management

The “Bond Strategy” for EXD is managed by James H. Evans. James joined Eaton Vance in 2008, and has over 25 years of investment experience primarily at M.D. Sass. He is a CFA charter holder. He received his B.S. in Operations Research and Industrial Engineering from Cornell University.

The “Options Overlay strategy” is managed by sub-advisor Parametric Risk Advisors, LLC. The co-managers are Ken Everding and Jonathan Orseck. Ken has a B.S. in Physics from Iowa State University and a Ph.D. in Theoretical Particle Physics from Yale University. Jonathan has a B.S. in Computer Science from the University of Pennsylvania and an MBA from Stern School of Business, New York University.

Factor #14: Other analyst coverage

I am not aware of any other analysts who cover EXD.

Option Overlay Strategy

The fund invests in “iron condors” using options on the S&P 500 futures contract. The iron condor strategy is a limited risk, non-directional trading strategy which is designed have a high probability of generating a small limited profit when the underlying security is expected to have low volatility.

The strategy tends to have a high win rate of small profits, but the strategy can experience a much larger (but limited) loss when the underlying moves outside of the expected range in either direction.

A typical iron condor uses four options, and the fund usually buys/sells options with four weeks left to expiration. I have estimated the option strike prices that the fund might use based on a current level of the S&P index future of around 1343. I have also added the closing option price of the one month March 2011 options as of Friday’s close.

  1. Sell- out of the money put (e.g. 1265 strike); Option price= 4.60
  2. Buy- out of the money put with lower strike (e.g. 1215 strike); Option price=2.69
  3. Sell- out of the money call (e.g. 1410 strike); Option price= 0.70
  4. Buy- out of the money call with higher strike (e.g. 1460 strike); Option price= 0.20

You can think of the iron condor as a combination of a bull put spread and a bear call spread. Another way to visualize the strategy is to think of the inside options you are selling as the income generators, and the outside options you are buying as insurance to avoid potential unlimited losses. Overall, the strategy generates a net credit when you put on the trade which is income for the fund.

The maximum gain for the iron condor strategy is the net credit received when you enter the trade minus commissions. For the prices above (omitting commissions) this would be:

Maximum Profit= 4.60 + 0.70 – 2.69 - 0.20= 2.41

This maximum profit occurs when all of the options expire worthless, and occurs when the price of the underlying S&P 500 futures contract ends up between the strike prices of the short put and the short call (e.g. 1265-1410).

The maximum loss for the iron condor is also limited, but is much higher than the maximum profit. It occurs when the ending underlying price falls at or below the lower strike price of the put purchased or rises above the higher strike of the call purchased (e.g. <=1215 or >=1460). In either case, the maximum loss is the difference in the strike prices minus the net credit earned when you entered the trade.

Maximum Loss= -50 + 2.41= -47.59

For this iron condor, the maximum worst case loss is about twenty times more than the maximum gain.

The iron condor is a market-neutral strategy that tries to collect a volatility risk premium which is the difference between the present implied volatility and the future realized volatility. The strategy tends to work well when the present implied volatility is higher than the typical level of realized volatility. Right now, with the VIX at only 16, the premiums earned are fairly low, especially on the out-of-the money call option.

By using options on the S&P 500 futures contract, the fund takes advantage of special treatment given to “Section 1256 contracts” where capital gains and losses are treated as 60% long term and 40% short term regardless of holding period.

In summary, both strategies used by the fund are tax advantaged:

  1. Income earned from tax-free municipal bonds is exempt from regular federal income tax.
  2. S&P 500 Index options qualify for treatment as “section 1256 contracts” where capital gains are treated as 60% long term and 40% short term regardless of holding period, so favorable tax rates apply for the one month option holding period used by the iron condor strategy.

Based on the above 14 bond factors, EXD is an interesting low risk holding for a taxable account to provide uncorrelated returns with equities and long term bonds. The current discount to NAV seems quite attractive.

But the current value of the VIX at 16 is low, and the risk reward profile of the iron condor strategy seems questionable now. I think EXD would be a more interesting investment choice if the VIX were to trade above 25 when the option premiums earned from the iron condor overlay strategy would be much more attractive.

Disclosure: I have a small "starter" position in EXD.