I've written a couple of articles illustrating the use of 'checklist investing' as a technique for screening investment candidates. The first in this series demonstrated application of this decision process to a REIT (article on BTB REIT), the next one applied a checklist to a common stock (article about Cummins (NYSE:CMI)). I am now using this piece to enumerate the checklist criteria that I utilize to screen CEFs (Closed End Funds).
To recap checklist investing: this investment technique has its roots in Atul Gawande's bestseller "The Checklist Manifesto", notable practitioners include Mohnish Pabrai and Guy Spier. The idea is to run every potential investment candidate through a list of pre-defined criteria, and to check off each checklist criterion as the security passes it. If a security clears majority of the criteria on the list, it is deemed worthy of capital deployment. Checklists are designed to remove the influence of emotion and confirmation-bias from investment decisions.
BlackRock Municipal Target Term Trust (BTT) is a closed end fund that invests primarily in tax-exempt municipal bonds with the objective of providing federal tax exempt income. Below is an evaluation of BTT against my checklist - unlike my REIT and Equity checklist, this one is less comprehensive, although I believe it hits all the key determinants that effect outperformance for a CEF.
1. Discount to NAV
Many closed end funds trade at prices below their net asset value, which essentially allows the investor to purchase underlying assets below their current market price. The reasons for existence of a discount vary, but primarily they revolve around -- a) high expense ratios, b) use of leverage and c) investor irrationality (CEFs are predominantly held by individual investors). Regardless, buying a dollar's worth of bonds or equities for less than a dollar is usually a good idea.
BTT shares are currently trading at a 9.5% discount to the value of municipal bonds within the fund's portfolio.
2. Target Term
Discounts are wonderful as long as the market eventually wises up to the fund's true asset value. A perpetual discount (or a widening discount with no foreseeable reversal scenario) diminishes the attractiveness of a discount.
Triggering events that could remedy a discount typically are: return-of-capital (more on why this works is covered later), share-buybacks (buying back shares below book value can often be the best use of cash by managements of both CEFs and corporations), or the appearance of a large activist shareholder who can arm-twist the management.
However, the catalyst that could fix a discount may never appear; furthermore, it is imprudent for an investor to count on the occurrence of an event that is outside his control. Because of this I like closed-end funds that have defined maturity period -- these are funds that are set up such that they are required to liquidate all their assets when a target year is reached and return the proceeds to shareholders. This guarantees eventual discount elimination to the fund holder.
BTT is scheduled to terminate at end of year 2030.
3. Low Expenses
CEFs are notorious for high management fees -- a traditional mutual fund investor usually gets a sticker shock when he sees CEF expense ratios that hover between 1.75% and 3.5%. However it needs to be kept in mind that a portion of these expenses result from interest expense on leverage that is employed by the fund, and this needs to be stripped out to arrive at the fund's true management expense ratio. Even after this adjustment, it is extremely rare to see expense ratios below 1% in the CEF space.
BTT has a total expense ratio of 1.06%, although the base management fee (after stripping out leverage costs) is just 0.55% making it one of the cheapest municipal bond funds out there (even when mutual funds are added to the mix).
4. Discount to Expense Ratio
Since CEFs tend to have high expense ratios, the discount-to-expense ratio formula is a good rule of thumb to see whether the discount can erode some of the high fees. The formula used is:
Discount-to-Expense Ratio = Discount % / Expense %
A number in excess of 10 is considered a good buy, in the case of BTT, this is:
9.5/0.55 = 17.3!!
A low expense ratio combined with wide discount makes BTT a outstanding bargain by this metric!
5. Discount in Excess of Fees
This is a variation on the previous metric; the idea here is to determine whether an investor can buy into the fund for close to free. By "free" I mean whether the annual management fees can be bent towards zero.
Every time any fund makes a distribution, the NAV reduces commensurately -- this is regardless of the fund type and whether it suffers a discount or not. However, when a fund at discount pays a distribution, a portion of that distribution includes an excess return (or alpha) that is produced due the discount (even if none of that distribution is return of capital, and is entirely sourced from income). This excess-return can be represented using:
Fund-Distribution * NAV-recapture
The discount on the BTT is 9.5%, therefore if the fund's shares could be sold at NAV, the gain would be 10.44%. Since BTT's current distribution rate is 4.38%, the excess return embedded into this distribution is:
4.38%*10.44% = 0.46%
The base management fee of BTT is 0.55%, but after subtracting out this excess return captured via distributions, the real expense ratio to the investor would shrink to a miniscule 0.09% (0.55%-0.46%)!
I learned this technique of evaluating CEF expenses from the writings of highly-respected Seeking Alpha contributor George Spritzer.
6. No Return of Capital
In a bond fund, return of capital is generally highly undesirable since it signals the fund management's laziness. By returning available capital to investors, the managers are choosing to artificially maintain distributions rather than generate legitimate interest income by buying new bonds.
To be fair, a managed distribution policy which includes return of capital is one of the most effective discount narrowing techniques that can be deployed by a fund's management. This is because the fund holder receives the full dollar value of the fund's capital payout, although he may have originally purchased it at below dollar.
BTT's distributions are currently sourced from income only.
7. Other Metrics
In evaluating CEFs, there are other factors that can be looked at such as: the undistributed net investment income (UNII) balance, the UNII trend over a year, the 1 year z-Stat etc. However for me a CEF trading at a deep discount with a built in trigger for capturing full NAV, combined with ultra-low real management expenses suggests a winner.
BlackRock Municipal Target Term Trust is trading at a discount to NAV, it has a defined maturity term, sports an expense-ratio below peers, and has a healthy income-only distribution. In my opinion this fund may be a good municipal bond holding vehicle for investors with an investing horizon that extends until 2030.
Disclosure: I am/we are long BTT.
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.