The supply and demand imbalance for municipal bonds has caused pricing to rise fairly significantly in the last six months. Foreign buyers, largely for the first time, are now a large driver of that demand disparity. This is the case even though these non-US purchasers do not receive the tax benefit. Their rationale is simple: any positive yield is beneficial to a Japanese or European investor when backing out the FX exposure. Muni bonds have very low default rates and can be used as a safe-haven investment.
US investors are also getting in the act with seven straight months of positive flows into municipals. Although, we would caveat that data point as many investors pulled money out in the second half of 2015 on higher interest rate fears.
This added demand is being coupled with decreased supply. Government borrowing has declined in recent years with just $330 billion in annual issuance over the last five years compared to $406 billion in the prior five years. In June, there was approximately $41.5 billion of gross issuance but net issuance was a negative $6.2 billion. In other words, supply is falling while demand is rising rapidly.
This has caused the 20-Bond GO index yield to fall from 3.42% at the start of 2015 to 3.18% and the Revenue Bond Index to go from 4.26% to 3.52% over the same period. This has closed the discounts on most muni CEFs in a relatively short-period of time.
We think the municipal market will remain in favor at least through the end of the summer and likely for the rest of year given the increase in foreign demand. Hiccups in the market can occur fairly often. In May and June of 2013, muni CEFs sold off dramatically in the wake of the Taper Tantrum initiated by Fed Chair Ben Bernanke. In the second half of last year, the discounts on muni CEFs widened to some of the largest discounts in the last 30-years due to fears of higher rates. And in May of this year, prices fell and discounts widened as the Fed hinted at a possible summer rate hike to interest rates.
These opportunities are rare but can often be used to initiate or add to existing positions with a margin of safety. For further information on our take of the market in general, please see our prior write-up titled, "Are Muni Closed-End Funds Overvalued."
While we think distributions could be cut further in the space due to the flattening of the yield curve, we think there are relative value opportunities. One of the ways we like to analyze muni CEFs is based on the net investment income (NYSEMKT:NII) 'yield.' Most of the investor base in closed-end funds can be myopic and focus simply on distribution rate and discount to NAV. Given the flattening of the yield curve and the 'headwind' to muni CEFs in that regard, we like the NII yield focus as it would indicate the longer-term viability of the distribution- as the distribution rate should be close to the NII yield over long periods of time. This can help identify potential cuts to distributions before they occur.
This list below contains all national (inclusive of high-yield marked in yellow) municipal closed-end funds sorted by NII yield. That data point is simply the net investment income from the most recent annual or semi-annual report divided by the market price. The second variable we would look at is the "excess" column which details the variance between the NII yield and the current distribution rate. That excess is the buffer in what the portfolio is generating and what it is paying to investors. Clearly, the higher the better for these two metrics.
The PIMCO Muni Income III (NYSE:PMX) tops the list with a NII yield of 6.3% and a distribution rate of 5.78%. The 0.49% excess effectively means the likelihood of a cut is low given what the underlying portfolio is generating in earnings. Of course, investors recognize this and have bid up the shares to a 9.70% premium over NAV. The MFS High Yield (NYSE:CMU), the second on the list, shows similar figures. But the credit quality of the fund is helping bump it to the top of the list with a significant amount of below investment grade issues (41% in high-yield munis or not-rated).
Our preferences would be for higher-quality muni portfolios, as those are the ones that are in high-demand as sovereign substitutes. In addition, we tend to look at the average bond price in the portfolio as well as the call schedule, if available. One must weigh the duration of the portfolio, yield, discount if any, call schedules, leverage, and excess NII yield, along with state breakdowns to come to a conclusion on which to put into a portfolio.
Our top pick in the longer duration group is the Invesco Municipal Trust (NYSE:VKQ). The 16.9 years average maturity places it at the lower end of the longer-dated muni group. It is a high-quality portfolio with just 5.5% that are below investment grade and another 7.5% not rated. Over 20% of the bonds are non-callable with just 15.6% callable in the next two years. The price is just over 3% below NAV with a NII yield of 5.87% and a small excess NII yield over distribution.
The Eaton Vance Municipal Income Trust (NYSE:EVN) is a high-quality name with a shorter duration of just 9.5 years. The fund recently cut its distribution, the second in the last year. They are now well out-earning their distribution which should prevent them from making another cut. The call schedule is just 3% this year, and 6% in each of the next two years. The fund does have a 7.8% allocation to Puerto Rico which is something to be aware of, but that is already more than priced into the fund.
Another choice would be the Invesco Quality Muni Income (NYSE:IQI), which trades at a 5.30% discount to NAV, contains moderate duration of 16.6 years, with 22.4% of bonds non-callable and just 12.3% available to be called in the next two years. The NII yield of the fund is 5.66% with excess over distribution of 19 bps.
Lastly, the Nuveen Premium Income (NPI) is a less interest-rate sensitive option with an average maturity of 9.8 years and an average bond price of $103.80 (double-discounts are very hard to find in muni CEFs today). The shares trade at a 7% discount to NAV with a 5.05% NII yield and a slightly negative excess over distribution implying the potential for a cut (UNII is positive by $0.02 providing a small buffer). But we think this is priced in to the fund given the discount and thus "cheap." The call schedule is decent with around 25% callable in the next three years.
|Name||Ticker||Discount||Distribution Rate||NII Yield||Maturity|
|Invesco Municipal Trust||VKQ||3.22%||5.77%||5.88%||16.8|
|Eaton Vance Muni Income||EVN||2.15%||5.05%||5.97%||9.5|
|Invesco Quality Muni||IQI||5.16%||5.45%||5.65%||16.3|
|Nuveen Premium Income||NPI||6.92%||5.20%||5.05%||9.8|
The muni CEF world continues to see very strong positive momentum in both price and underlying NAV performance. We really see little that will abate the rally fundamentally as the lower-for-longer environment continues. However, there will always be hiccups and investor panic that presents buying opportunities for investors. The current discounts are very tight so the buying environment is much weaker than six months ago. However, for current holders of muni CEFs, we think there is plenty of room to run given the market dynamics at play. In addition, new investors could choose a few value plays that still exist by using the framework we established above.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VKQ, IQI over the next 72 hours.
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.
Additional disclosure: This is should not be considered a recommendation for purchase. Please perform your own due diligence. The specific securities identified and described does not represent all of the securities purchased, sold, or recommended, and the reader should not assume that investment in the security identified and discussed was or will be profitable.