Is It Time to Buy Municipal Bond CEFs?
The first half of 2016 saw a huge rally in munis, but for the past few months that rally has stalled. This chart compares the Nuveen High Yield Municipal Bond Fund (MUTF:NHMRX), a reasonably good proxy for muni-bond CEFs, to the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and the iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG).
The rally had been marked by an influx of money into municipal bond funds as seen in this next chart where we see that the influx has turned negative from June's high.
Observers of these trends have noted that an important driver of the inflows of funds into municipal bonds came from international investors, this despite the fact that they do not benefit from the US income tax exemption for municipal bond income. For many international investors, the safety of US municipal bonds more than offset the modest returns one receives. Of course for US investors those modest returns are enhanced by their tax-free status, so investors in the higher brackets receive an attractive taxable-equivalent return along with that safety.
I know many readers will blanch a bit at my referring to municipal bonds as safe. I know this because my comment streams in my municipal bond articles always include input reflecting the tin-foil hat brigade's certainty that US municipalities are heading for bankruptcy, any day now. Fact is, the only US fixed-income asset class safer than municipal bonds is treasury bonds, and they too ran up strongly through the first half of the year. For a discussion of muni-bond safety, see my July article (Stocks Rally, Muni Bonds Swoon: An Update On Muni Bond CEFs).
As I noted I have been looking at municipal bond CEFs for potential buys. I have spreadsheets from 5 July, 12 July 2016 and 27 August 2016 which I'll be drawing from in my discussion. Price movement (average of 92 funds) through last week's close looks like this:
Market prices began declining in early July coinciding with the decrease in money flowing into muni-bond funds. NAVs soon followed. From 5 July through Friday, the average market price lost 3.76% while the average NAV lost 2.01%. The rate of market price losses accelerated relative to NAV losses over the past three weeks.
Discounts and Premiums
Obviously, discounts have deepened as a consequence.
On 5 July the median discount was -0.70% and 40.2% of the 94 national funds were priced at a premium. At week's end the median discount was -2.16% and the percentage of funds at a premium was down to 27.9%.
This next chart compares discount/premium status of the 93 national muni-bond CEFs at the week's end.
Compare this current chart to the 12 July Chart and we see how strongly the discount/premium spectrum has shifted toward the discount end of the scale.
The ten funds with the deepest discounts are:
Will this trend continue? CEFs tend to revert to mean valuations. Z-scores are a good indication of how much reversion may be in store, and particularly in the direction one might expect that reversion to take. To review, negative Z-scores indicate values below the mean value for the time period under consideration; positive Z-scores indicate values above the mean. The absolute value of the Z-score is the standard deviation over the period. Keep that in mind: Z-scores measure the number of standard deviations from the mean. That means they do not represent changes in absolute values. For a fund with high variation (i.e., high standard deviations) in its discount/premium status, a given Z-score can represent a much greater move than an identical Z-score of a fund with a more stable premium/discount history.
Here then are the distributions of current Z-scores for premium-discounts for the muni-bond CEF universe (top charts) and for comparison the scale for 12 July (lower charts).
One-year Z-Scores (17 September, top and 12 July, bottom)
Six-month Z-Scores (17 September, top and 12 July, bottom)
And three-month Z-Scores (17 September, top and 12 July, bottom)
In July, only two of the 92 funds have a negative Z-score for the year. But the trend was clearly moving in the other direction. For 3 month Z-scores, that number was 45, just under half. The trend has continued. For the current 3 month period 87 funds (82.8%) have negative Z-Scores.
The most negative current Z-scores for each time frame are:
Falling prices and deeper discounts inevitably lead to higher distribution yields, although there has been a number of modest distribution cuts (a consequence of the continuing low-yield environment) among muni-bond CEFs that tends to counter that relationship somewhat.
Here is the recent history of yields at market price and NAV.
Gains in market yield have, of course, outpaced that for NAV yield because market prices are falling at a greater rate.
Best yielding funds at market value and NAV are shown next.
Top Ten Yielding Funds at Market Price and NAV
Discount Status vs. NAV Yield
This is, as I've noted in the past, a consistent correlation between NAV yield and discount. Funds tend to revert to the regression (trend line) equilibrium, so funds that fall below that trendline are generally worth a close look. Here is the current relationship for discount vs. NAV yield.
With 92 funds the chart is cluttered to the point that it is impossible to read, especially in the region we are most interested in, below the trend line, at moderate to high NAV yield values. So here's a rescaling of the chart to emphasize those funds.
Nuveen funds as usual carry the deepest discounts relative the NAV yield. It's never been unclear to me why this is the case, but this sponsor-effect needs to be taken into consideration when evaluating funds from this trend. Eli Mintz, who first pointed out the relationship between Discount and NAV yield in muni-bond CEFs (here), discusses the sponsor effect.
These trends are positive for a muni-bond CEF buyer, and I have been waiting for improved valuations in the municipal bond market to add to my holdings. However, I intend to put off any decisions at least until the Fed makes its call this week. My guess is that they will not be raising rates just yet, but if they do, muni bond valuations should improve still more over the coming weeks.
Then too, there is a pressing question: Is this the overdue bond correction? Many observers seem to feel that it is. See Jeff Miller's typically well researched piece on the subject this weekend for some details (Weighing the Week Ahead: Is the Long-Awaited Bond Correction at Hand?). Again, a lot will depend - at least in the short term - on how the Fed moves this week, but this is yet another reason to hold off on any immediate buy.
I will note that there have been more than a few funds that have cut their distributions over the past few months and more cuts may be coming. Yet another reason to wait.
Finally, I'll add here one last point I'll add for your information. When muni-bonds are described the tax-equivalent yields cited are invariably based on the highest marginal rates, a fiscal environment few of us enjoy. So, here are current taxable-equivalents for the category range of market yields for IRS marginal tax rates from 25 to 39.6%.
Median tax-equivalent yields from 7 to 8.7% are very attractive returns from what amounts to the second-safest of fixed-income asset classes. One can find fixed-income CEFs with higher yields but those will always come with a marked decrease in safety.
I'll follow up with a discussion of individual funds sometime this week.
All uncited charts and images are my own. Data used to populate the charts is from cefanalyzer.com.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I have no ties to the financial or security industries in any form. My interests are strictly personal. The banker part of the nym has absolutely no relationship to the profession of the same name. Readers should be aware that I am an investing novice. I do not give advice; what I publish is an annotated version of my research notebook. Anyone who finds any securities to be of interest will necessarily want to do his or her complete research and due diligence before acting on that interest. It would be foolish to rely on my conclusions without having done so.