Are Muni Closed-End Funds Overvalued?

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Includes: NVG, NZF, VKQ
by: Alpha Gen Capital

Summary

The muni yield curve continues to flatten which has led to an unprecedented amount of distribution cuts in muni CEFs.

Muni CEFs have rallied strongly since December when the fear of higher interest rates widened discounts to near record levels.

Munis can provide a strong diversification benefit to taxable bonds and a key alternative to treasuries given the safety.

New Federal Reserve Board rules along with likely follow-ons by the OCC and FDIC could significantly increase the demand for munis.

Last December, Muni CEFs were trading at an average discount of 13% but today trade at an average premium of 1.8%. That is a large move in a relatively short period of time and is reminiscent of the Taper Tantrum scare back in May/June of 2013. During that event, discounts widened significantly in a few weeks' time creating strong buying opportunities. But are today's muni bond CEF yields and premia sustainable?

On June 1st, Nuveen, BlackRock (NYSE:BLK), and Eaton Vance, the largest municipal bond CEF sponsors, cut the distribution on 66 of their 128 combined muni CEFs. What was the main reason for the cuts? For one, muni bonds issued with over ten years to maturity are typically callable by the issuing entity. With interest rates falling so quickly to new lows, and muni rates reaching all-time lows, issuers are quick to pull the refund trigger.

Yields have plunged coming into June after being essentially flat for April and May. The 30-year muni market data (MMD) benchmark hit just 2.20% on June 24th, following the Brexit vote, an all-time low. Supply has been strong but demand has been even stronger due to (for the first time overseas demand. The current environment is odd in that foreign buyers are snapping up muni bonds for which they receive no tax benefit due to the low and often negative rates for triple-A rated government debt in their countries.

According to the Federal Reserve, international investor participation in muni bonds has grown by 44% from 2009 through 2015. This demand has pushed up prices and down yields for these credits. Our tax-free muni bond CEF portfolio is now up over 12% year-to-date nearly through the first half of this year. What should we expect in the second half of the year?

Flattening Yield Curve And Calls

The flattening muni yield curve is starting to affect muni CEFs, hence the distribution cuts. These funds typically have longer durations than taxable bond CEFs. Funds borrow short term and buy long-dated muni bonds with the proceeds. If the spread between the short rates and the long declines, the amount the fund manager can generate via leverage is reduced. In October, the muni yield curve was fairly steep with the muni yield curve around 10 bps at one year, which rose to over 250 bps around 13 years and 315 bps for 30 years. A spread of 305 bps. Today, the short end of the curve is around 60 bps while the long end is at 2.20%, for a spread of just ~160 bps.

This flattening has led to the string of distribution cuts mentioned earlier. We think investors have been missing this point and instead are focusing on the momentum of the category, chasing performance. If the short end continues to rise - 3-month LIBOR sits at 0.64%, up from 0.28% a year ago and 0.66% a month ago - we would expect to see further distribution cuts to the high payouts on most muni CEFs.

The second whammy is the callable nature of most long-dated muni bonds. This opens up the PM and thus the investors to significant reinvestment risks. As bonds get called, the PM is forced to reinvest the capital at the much lower rates of today compared to when they were issued. This reduces the overall yield of the aggregate portfolio, all else being equal. The fund could be in a position to be forced to cut their payout as the combined holdings generate a reduce rate of interest.

Why Should You Go Long?

The above sounds very gloomy and may entice a holder or two of muni bond CEFs to re-evaluate their holdings. However, any analysis should be done within a relative valuation framework. Munis can be a strong substitute for treasuries given the very low risk of their A-rated securities. The default rate on A-rated or higher muni bonds is next to nothing (it is nothing for triple-A and effectively nothing for double-A). Since 1986, there have been no triple-A rated muni bond defaults. You have to move down to double-B rated munis before the default rate exceeds even 1%.

In comparison, corporate bond default rates are much higher as the chart below shows. On a tax-adjusted basis, muni bonds even at these prices, still offer one of the best risk-return trade-offs in the market. While 10-year GO yields for munis are 1.3% compared to 1.5% for similar duration treasuries, the tax-equivalent yield for high earners is over 2.3%. The risk is only slightly (and we mean slightly) higher for muni bonds, the yield is over 80 bps (or 53% greater). The revenue bond index is now yielding a tax-free 3.52%, with marginally more risk than most GO bonds.

Additionally, diversification, especially among the fixed income portion of an investor's asset allocation is very important. The Barclays muni bond index has a 10-year correlation to the S&P 500 of just 0.09. Even among fixed income, they provide a significant diversification benefit with a correlation of just 0.55 to corporate bonds, and 0.34 to high-yield bonds. Lastly, as compared to US treasuries, muni bond correlations are just 0.30.

Our most important thesis for holding munis at these levels, despite the run they have had, is on April 1, 2016, the Federal Reserve Board finalized a rule for banks to include muni bonds as safe liquid assets. The rule had its genesis from a 2014 rule aimed at making sure banks can increase liquidity during times of financial stress in order to fund operations. This led to a requirement for banks to hold more cash and liquid securities that are easily converted to cash. Initially, muni bonds were not slated to be included as securities that would qualify, but subsequent amendments in 2015 allowed some muni bonds to qualify.

The ruling should allow banks to hold smaller issuances, which are now the issues that are more typically insured. The market hasn't moved on the ruling yet, as the Office of the Comptroller of the Currency and the FDIC need to make similar rulings on liquidity towards capital requirements. The Fed only has jurisdiction over the bank holding companies, and not the banks themselves, which are overseen by the other two regulatory bodies.

States and local government tax revenues continue to recover from the financial crisis with fourth quarter 2015 tax receipts up 4.2% compared to 2014. Importantly, individual tax receipts was the largest contributor to growth rising 5.6% yoy with property taxes second with an increase of 5.3%. State budgets are in their best shape since the financial crisis and there is no stresses in most municipalities. Certain geographies bear watching, as always, with Illinois being the top of the list (Connecticut, New Jersey, and Kentucky as well).

Our three favorites in the space include the Nuveen Dividend Advantage Municipal Income Fund (NYSEMKT:NVG), Invesco Municipals Trust (NYSE:VKQ) and the Nuveen Dividend Advantage Municipal Fund 3 (NYSEMKT:NZF).

Ticker Yield Tax-Equivalent Discount
NVG 5.61% 9.91% -7.03%
NZF 5.78% 10.21% -8.10%
VKQ 5.86% 10.35% -4.65%
Click to enlarge

We still believe there are bargains in the space and noted a few above. NVG and NZF recently increased their distributions, which would indicate to us that management feels comfortable with their earnings capabilities. In addition, the funds have some of the widest discounts in the category.

Conclusion

While the spreads of muni bond CEFs have closed in the last seven months, the yield on the bonds still represent an important diversification benefit while demand should only rise with the new Federal Reserve Board ruling. Tax-equivalent yields offer a strong alternative to investors from low-yielding treasuries. While the duration of these funds warrants caution, should the unlikely event of higher interest rates materialize, the safety and diversification tends to be overshadowed.

The flattening of the yield curve is the more acute danger for these funds as spreads tighten between the short-end borrowing and long-end bond acquisitions. Further cuts to distributions could be in store for investors over the next several months should LIBOR inch higher.

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Disclosure: I am/we are long NVG, NZF, VKQ.

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.