I made a cardinal sin about six weeks ago when I stepped in front of the municipal bond CEF bus and added to some long-term positions based more on comparative valuation than on anything else. As it turned out, valuations didn't help these funds from six weeks ago.
I should have taken advice from myself in knowing that the moves in fixed income markets are often times like moving battleships, i.e. once they get going, momentum tends to keep them going the same way for a while. I wrote as much back in March of 2013 when I cautioned investors in this article, Muni Bond CEFs Take A Beating Again, that it was still too early to step into these funds when many were trading at premiums and all-time highs just a few months earlier.
It wasn't until the second half of 2013 that the risk/reward in muni CEFs started to shift back to the reward side as prices continued to drop, discounts continued to widen and the issues that were facing municipal bonds at the time, i.e. rising rates, threat of defaults in Detroit, Puerto Rico and secondary markets like Stockton, and even a debate on the tax-free status of municipal bonds as part of a balanced budget proposal, were all making news headlines, usually a sign that a perfect storm was howling at its worst.
It got so dire during this period that I even wrote in August of 2013 that what was going on in Detroit might actually be a catalyst to help turn things around when I wrote this article, Will Detroit Save The Municipal Bond CEF Sector? This turned out to be largely accurate as cities and other municipalities reacted to the growing number of frontal assaults by reminding Washington DC and Congress of what the municipal finance sector meant to the economy.
Here is a snippet from my article above, including a link to a letter which I would encourage you to read:
Here is a copy of a letter from a broad coalition of municipal and private sector interests sent to Senate Majority leader Harry Reid and Senate Minority Leader Mitch McConnell this past March. And since the Obama administration has consistently called for a cap on the muni bond exemption as part of an overall balanced budget proposal for 2014, there have been ongoing efforts by the public sector to stress the harm this would cause to the public financing. Though the Obama administration is obviously targeting wealthier investors who are the primary buyers and holders of municipal bonds either directly or through mutual funds, there is ample evidence that the elimination or reduction of the tax-free bond status would hurt cities and counties much more than individuals who are in high tax-brackets or who are high earners.
A report from the National League of Cities, National Association of Counties, and the U.S. Conference of Mayors estimates that if a proposed 28% benefit cap on interest income on municipal bonds (one of the proposals being floated by the Obama administration) was in place over the last ten years, it would have increased the borrowing costs to state and local governments by over $173 billion. Complete elimination of the cap would have increased borrowing costs by over $495 billion.
Are we back to those days again? In a sure sign of piling on when the chips are down, now we're hearing that the muni tax exemption might even be scrutinized by the Trump administration as an offset to reducing income taxes. Really? Something that Obama couldn't accomplish will now be on the table with a Trump administration?
If infrastructure spending and improvements are going to be the hallmark of the new administration, why would you essentially castrate the ability of most municipalities to bring new issues to market when one of your greatest sources of new infrastructure financing will be the municipal bond market?
When news like this pops up, then you have to think we're getting close to an interim bottom but that will only be temporary if interest rates continue to rise up. Back in 2013, the bottom in municipal bond CEFs wasn't realized until mid-December of 2013 as tax loss selling and ongoing uncertainties conspired to drop these funds to their lowest price and NAV levels since the financial crisis of 2008.
But the risk/reward had finally tilted dramatically to the reward side and with some clarity finally starting to appear on the Detroit bankruptcy process for example, I encouraged investors to step up and buy municipal bond CEFs, pretty much any of them, when I wrote my last article on the subject that year, The Sad State Of Municipal Bond CEFs.
From that point on, muni CEFs never looked back and the sector turned out to be one of the best performing asset classes over the next two years. Until the past two summers when interest rates reared their ugly head once again.
Fast Forward To 2016
I point all this out for two reasons. One, issues in the municipal bond markets back in 2013 have some similarities but also stark contrasts to the issues today. And second, it took time for these issues to be absorbed in the markets before municipal bonds and municipal bond funds could stabilize and move back up. Because whereas the equity markets have essentially been on a ramp up since the financial crisis of 2008, the bond markets have been on a seesaw.
The greatest similarity between 2013 and 2016 is that interest rates have been steadily moving up since both summers though this year, it has been even more dramatic since the election of Donald Trump. The iShares 20+ Treasury Bond ETF (NYSEARCA:TLT), has dropped from $130.09 before Trump was elected to $120.85 last Friday, or a drop of 7.1% in less than two weeks. That is an incredible move based on nothing more than expectations.
Since nobody foresaw a Trump presidency and in fact, the consensus was that the equity markets would drop precipitously if he was elected, how much credibility should we give this move in interest rates and even the equity markets, when these spikes appear to be based more on a campaign agenda of bombastic promises than on what could realistically be expected once the details are laid out?
Just how out of touch has it gotten? Take a look at this chart from a recent article, Everything Is Awesome!, by one of my fellow contributors, Lawrence Fuller. This chart shows the recent divergence of the S&P 500 with the Goldman Sachs Financial Conditions Index, a widely followed gauge of credit access based on a number of factors, including interest rates, credit spreads and the US dollar.
Usually, these two indices match up pretty well but notice that divergence on the far right? That's what you call a significant anomaly between expectations and reality.
Barron's this past weekend also dedicated several articles to the bond market rout as well as the dramatic rotation going on in the equity markets. If you want to know how this interest rate move compares historically, here is what Barron's said...
The flight from bonds made for the biggest two-week loss in more than a quarter-century in the Bloomberg Barclay's Global Aggregate Index, which fell some 4%, Bloomberg reports. The outflows from municipal and emerging market bond funds were especially acute, about $3 billion and $6.6 billion, respectively.
It seems to me that if Mr. Trump wants to see a US growth revival, he is going to need to keep interest rates as low as he can, not only for his own spending stimulus but to offset the headwinds that are already appearing in higher short-term rates (1-year LIBOR has almost doubled over the last year and the 3-month LIBOR has almost tripled).
Any acceleration of higher rates across all benchmarks will just make business transactions in real estate loans, auto loans, business loans and on down the list just that much more difficult and certainly more expensive. In other words, a Trump election has probably done more to move the needle towards an economic slowdown than a growth spurt out into the future.
What Are The Differences Between 2013 And 2016?
Getting back to municipal bond CEFs, there are some significant differences this go around vs. 2013. The biggest difference is that municipalities are in much better financial health today than in 2013 as the talk of bankruptcies and defaults has largely fallen out of the news. You can thank higher property values, better business conditions, fuller employment and higher wages for all that. Of course, all of that could change but the fact remains that most municipalities are in their best financial shape in years.
Pension shortfalls seem to be a more serious topic this go around, particularly in a number of states across the country when it was primarily an Illinois issue back in 2013. But I sincerely doubt you will ever see municipal bonds take a subordinate role to pension liabilities in a pecking order of what gets paid first, if it ever came to that.
That's because municipalities are loathe to jeopardize bond payments and risk having future bond deals dinged with higher rates. No municipality wants to pay higher interest rates on their bonds than they have to and this is a big reason why default rates are so low for municipal bonds, even the junkiest rated of municipal bonds.
Certainly, pension liabilities could have an impact on credit ratings and the ability or cost of a municipality to issue new or refinance existing bonds but other than that, I don't see any added fallout effect on municipal bonds if the pension liability issue continues to drag on. If anything, pension liabilities could force municipalities to have to offer higher yields to compensate for the added risk, something that would make municipal bonds even more attractive to investors no matter where interest rates go.
But just to show you how municipalities are dealing with this issue, Nuveen included this in their Municipal Market 3rd Quarter review...
Chicago GO bonds were downgraded to Ba1 by Moody's in mid-2015, due to the city's large and growing pension obligations with a combined funded ratio of just 23%. Since then, the city has made significant progress on improving its operating budget and identifying new revenue sources to increase pension contributions. The city announced the smallest operating deficit in more than a decade, at $137 million on an overall budget of $3.7 billion. This relatively manageable figure is expected to be closed by cost cutting and improved government efficiency.
To address the underfunding of its largest pension fund (the municipal employees' pension), the city announced new reforms combined with a new revenue source. The reforms require new employees to make higher contributions and certain existing employees will have a choice between keeping existing benefits or retiring two years early if they increase contributions by 3%.
To generate revenue for increased pension contributions, the city will levy a tax on water and sewer services. The new tax is expected to generate $56 million in 2017 and would provide $240 million in revenue by 2021. Among the 30 largest U.S. cities, Chicago's water and sewer charges are currently the third lowest. This combination of reform and a new utility tax is intended to achieve a 90% funded ratio for its largest municipal pension plan in 40 years.
In response to these new announcements (including City Council approval), Chicago's credit outlook improved to stable from negative at Standard & Poor's and Fitch. S&P rates the city BBB+ while Fitch rates Chicago BBB-. Investors also approved of the moves, as GO bond spreads narrowed by approximately 90 bps during the quarter.
Underfunded pensions is a problem that will not go away anytime soon but the impact on the municipal bond market should be more indirect than having any direct relationship to the health and well-being of the sector. Other more direct issues that have come with a Trump presidency include his plan to lower the top tier income tax bracket from 39.6% to 33%, thus making municipal bonds comparatively less attractive to wealthy investors.
This certainly was not in the cards back in 2013 with an Obama administration, though I believe the impact on municipal bond demand will be negligible. Though the markets seem to be pricing in how much less attractive municipal bonds would be already, in my experience with wealthy investors, they don't like to pay taxes at all. Mr. Trump himself is a good example of that.
The Case For Municipal Bond CEFs Now
Besides, with this latest drop in market prices, national municipal bond CEFs now offer yields mostly in the 5.0% to 6.5% range on leveraged funds, which is of course, Federal tax free. Thus, even using a lowered 33% tax bracket, 5.0% to 6.5% yields equates to 7.5% to 9.7% yields on a tax-equivalent basis. State municipal bond CEFs for in-state investors would be even more advantageous. That's pretty darn attractive and even if there are slight cuts to distributions in the future, something that investors should probably expect but not panic over, yields on muni bond CEFs are still going to offer some of the most attractive yields among any asset class.
And what do you get when you buy a municipal bond CEF? Typically, you're going to get leverage of around 30%, which dramatically boosts the yield of the fund but also boosts the risk of the fund. Leverage costs to the fund may also increase in a rising interest rate environment and that's where distribution cuts could come into play depending on what form of leverage the fund uses and what coverage ratios they use.
But what you're also going to get with municipal bond CEFs are funds that own nothing but municipal bonds across a wide variety of credit ratings, maturities, sectors and states. That may sound trite but really, there is nothing esoteric about what they own, nothing hidden, nothing tied to derivatives or anything like that. And municipal bonds are typically the investment of choice of wealthy investors because they are conservative and they pay federal tax-free interest. They are also generally state tax-free as well if you so happen to own bonds in the state you reside in.
Now owning muni bond funds, i.e. mutual funds, ETFs or CEFs, is quite a bit different than owning individual bonds. Disadvantages with funds is that they are usually perpetual and thus don't mature though more and more municipal bond CEFs are coming out as term trusts with maturity dates. Though you are not guaranteed to get your investment back at maturity, you will get the NAV back; thus, the theory is that the market price will not stray too far from the NAV while you own it. Another advantage of CEFs is that they are not subject to redemption demands whereas mutual funds are. Being forced to sell securities to meet redemption demands at market lows is something portfolio managers of CEFs don't have to worry about.
Some municipal bond CEFs do have maturity dates and prices. The BlackRock Municipal 2030 Term Trust (NYSE:BTT), $21.56 market price, $23.01 NAV, -6.3% discount, 4.5% current yield, is structured to return $25 in 2030. Though the $25 is not guaranteed, virtually all of the fund's holdings mature around that year so unless something dramatic happens between now and 2030, there is no reason why you would not get $25 back from a $21.56 investment today.
BTT, along with the Nuveen AMT-Free Quality Municipal Income fund (NYSE:NEA), $13.08 market price, $14.56 NAV, -10.2% discount, 6.2% current market yield, were both just highlighted in Barron's this past weekend in this article, Bonds Suddenly Look Like A Bargain, as particularly attractive in the muni bond CEF space (subscription required).
NEA, which I own, is the largest national municipal bond CEF at $5.8 billion in total assets ($3.8 billion in net assets) after three Nuveen municipal bond CEFs merged into NEA earlier this year. This makes the fund extremely liquid and at a -10.2% discount, NEA also trades at one of the widest discounts of all muni bond CEFs.
Here is NEA's 5-year market price and NAV chart (does not include monthly distributions) with some commentary along the way. Below that is NEA's 5-year Premium/Discount chart. Though I'm using NEA as an example here, most muni bond CEFs would have similar chart patterns.
On the Premium/Discount chart, you can see that historically, NEA is about at a level where it should find support. Remember, back in 2013, talk of municipal bankruptcies and defaults were headline news whereas today, the municipal market is on much more solid ground. Certainly, the industry has come a long ways since then even if many municipal bond CEFs are not that far from those 2013 price levels. In fact, most funds have at least retraced back to their 2015 lows as anticipation of the Federal Reserve's first rate hike in nine years which occurred in December of 2015.
Jim Robinson, who manages the Robinson Tax-Advantaged Income Fund (MUTF:ROBAX) and who is one of the most knowledgeable and experienced asset managers in the tax-exempt CEF space, forwarded me some interesting statistics on where we stand right now.
The above chart shows the historic Premium/Discount level for the municipal CEF universe going back 26+ years. The red X is where we were exactly one week ago after last Monday's drop which actually pushed the percentile rank down even lower to the 3rd percentile.
What this means is that there have been only two other times in the last 26+ years when the municipal bond CEF space was at such a low valuation reading. The first was during the period leading up to the Bush tax cuts in the early 2000s and the second was during the Lehman crisis in 2008. Both times, municipal bond CEFs recovered, and sometimes dramatically so as fund sponsors are more likely to step in and support the fund prices when they get down to these valuation levels.
If you're interested in considering the Robinson Tax-Advantaged Income fund as an investment, you can learn more about the fund at this link, Liberty Street Funds. Essentially, the fund's investment strategy is to take advantage of the wide discounts in the municipal tax-exempt CEF space while hedging away a portion of the NAV risk by shorting various US Treasury futures contracts.
The greatest risk to the municipal bond CEF space and indeed all of fixed-income and interest rate sensitive sectors is that all of the fears that have been on display recently, i.e. expectations of sustained inflation and thus, a Federal Reserve given carte blanche to raise rates multiple times over the next few years, plays out.
If such a scenario occurs, then the attractive valuations I relied upon in the opening statement of this article will continue not to matter as municipal bond CEF NAVs would just continue to drop alongside of their market prices.
However, there is reason to believe that Mr. Trump's wishlist of things to accomplish will have to be scaled back significantly. Already we are seeing a coalition of Democrats and even some Senate Republicans gearing up for battle on a number of fronts. Then there is the effect of rising interest rates and a rising dollar already which may provide headwinds to any growth or inflationary spurts before they even have a chance to pick up steam.
This may not stop the Federal Reserve from hiking rates in December and they may go on to hike more times in 2017, but if say, three 1/4 percent rate hikes over the next year or so were to occur, this would not be the death knell of the fixed-income markets. In fact, I would call to your attention what happened in the near term after last year's rate hike. Bond yields moved back down (prices up) and it was the equity markets that got hit in January and February. Indeed, sometimes fear is worse than reality.
Disclosure: I am/we are long NEA.
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.