Bubble In Municipal Bond Closed-End Funds An Update 6 Months Later

| About: iShares National (MUB)

Summary

The municipal sector is retracing in line with treasuries.

Individual Muni CEFs are cutting distributions and widening their discounts to NAV.

We are seeing some individual CEFs that provide a good entry point statistically.

Less than six months ago municipal closed end funds (CEFs) were showing signs they were overheating. All 176 municipal bond CEFs were trading at 2 standard deviations above their average 52 weeks premium/discount to NAV. I argued this was unusual and couldn't continue for long; premium/discounts would eventually come back to normal. I even shorted a few Muni CEFs hedged with a long position in Muni Bond ETF, MUB.

Most Muni CEFs put in a top around late June, early July and have now returned to more normal levels compared to NAV. In fact, one of the CEFs I shorted in my first article, Invesco Value Municipal Income Trust (IIM), I recently bought as it was statistically undervalued. I covered this buy here, and I still think this trade can make money.

In this article I will take a statistical look at Muni CEFs. They have pulled back, but are they a buy?

An Overview

A municipal bond is issued by a state, municipality or county. They come in all shapes and sizes, but their main appeal is their ability to provide tax-free income. A coupon of 5% will yield more after tax compared to a 5% corporate bond.

Closed-end funds leverage the yield and allow an investor to diversify and spread the risk over a range of munis. They also focus on specific types such as high yield or munis from certain states. When choosing a CEF, there are many considerations, and an investor must look beyond only yield and discount. Use of leverage, size of the fund, and distribution ratio are all important. I get some comments from investors who would never buy CEFs with too many bonds from states such as California. This is certainly a consideration, but everyone has their own rules and risk tolerance.

As with any fixed income investment, there is interest rate risk. This is clearly seen by the recent sell off in T-bonds and how it has had knock on effects in markets such as Muni CEFs.

Valuations

Closed-end funds track the NAV of the municipal bonds they hold. There are always discrepancies; no fund will track its NAV 1:1, but there will be an average discount or premium that is followed for the majority of the time.

The z-score compares a fund's current discount/premium to the average discount/premium. The calculation is as follows:

Z = (current discount - average discount) / standard deviation of the discount

A negative z score means the current discount is lower than average, and vice versa. More importantly, it shows us how significant this discount is. A fund is expected to trade between a z score of -2 and +2 for 95.5% of the time. So when we see outliers, we can be fairly certain there is a temporary mispricing.

An overview of the current Muni CEF z-scores can be seen below:

source: Cefconnect, author's database.

Now let's look at the same table back in April:

The average discount has widened by almost 1%, but still far away from the 5.73% which used to be the average back then. The z-score looks normal at this levels, but this is due to the shift in average discount and can be a misleading indicator. I would rather concentrate on the 2% average discount rather than the normal looking z-score in the current situation.

In my April article I used z-score ratio to conclude that the municipal CEFs are overvalued and I can proudly say that I warned you, but in fact my thesis is currently not proven. Even though MUB really retraced:

MUB Chart

MUB data by YCharts

It is still higher than it used to be on April 22. My whole idea was not to predict the direction of the market anyway, but to say that discounts will widen. I still think that the 2% discount average for any Muni CEF is not well deserved. If the yield euphoria is gone and there is a slight change in sentiment we will probably see further widening of the average discount. Even worse, discounts can widen with no reason at all. They seem to have random behavior.

A perfect example of an overvaluation

I wrote two consecutive articles on NEV that can be seen here and here. This picture says it all:

Click to enlarge

I am currently monitoring the sector for undervalued ones and will probably have some of them coming if the trend of cutting distributions continues. Nuveen munis also deserve a deeper look statistically and will probably do an article about them. Another respected Seeking Alpha author started a discussion on them here.

Is 2% discount deserved for a Muni CEF?

I cannot find any reason for these funds to have such a low absolute discount compared to other closed end funds. Will be glad to have a discussion about this in the comment section, because my main conclusion after running a lot of regressions is that this is a random behavior

Mispricing against benchmark

A way to detect mispricing is to construct a basket of funds and compare it to the benchmark Muni Bond ETF, MUB. The MUB has a very high correlation to the NAV of all the CEF holdings, which makes it a reliable comparison.

We constructed a portfolio of 10 CEFs and compared its profit to that of MUB. Each portfolio is constructed in a way that the profits of each portfolio move with a slope of 1.

Click to enlarge

source: author's software

Currently The basket of this 10 muni funds is almost 4 standard deviations cheaper compared to MUB which is around 2.5% in absolute value. This is not a large deviation in absolute terms and even though it looks nice on the chart, do not forget that the average discount for the whole group is just 2%.

Author's view of the situation.

If you are a buyer in this situation who is not scared of higher rates and are looking for some tax-free yields concentrate on funds that have already cut its distribution. This is a trend in the sector and future cuts will probably be the norm for most of the funds in the sector. While I have always defended the thesis that dividend policy should not affect market pricing, there are many examples in the practice that oppose this basic financial logic. The last example is the fund IIM for which I wrote an article and several days later there was another one, by a respected author. Be careful not to pay a high premium for a fund that is about to cut its distribution. The best way to do that is to buy after the cut. IIM is a perfect example of the strategy and will save you from dividend cut risk at least the first one you are patient enough to wait for.

Conclusions

Muni CEFs have retraced, but discounts still show inflated levels. Don't concentrate too much on 52 weeks z-score, because there was a big enough period of overvalued pricing that can make a 2% discount look normal. Be prepared for dividend cuts and at least try to buy the same NAV after the dividend cut, not before that. We are still in a mini bubble mode, but nothing serious to give good arbitrage trades so you have to be directional and either invest or know your stops if you are trading.

Disclosure: I am/we are long IIM.

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.