Over the last 18 months, I have written a series of articles on some specific municipal bond closed-end funds. The muni bond asset class has performed quite well over this period, but we are now facing stronger headwinds due to higher valuations (lower discounts to NAV or premiums) and the potential of lower NAV prices in the future if interest rates start to rise.
In the four years since 2008, there have been major changes in the financing of muni bond CEFs. The CEF auction rate preferred (ARP) market basically froze up in early 2008. There has been no new ARP financing since then. There was about $60 in billion in ARP financing outstanding in 2008, but about 80% has been redeemed over the last four years.
A number of new leveraging options to replace ARP financing have been developed for muni bond CEFs, but these newer financing tools are currently more expensive than ARP financing:
- Variable Rate Demand Preferred (VRDPs): These are preferred stock with a put feature, and can be purchased by money market funds. They have a letter of credit from a financial institution that acts as a liquidity provider. The maturity date must be less than 397 days. VRDPs are traded in the retail market and are only available to qualified investors.
- Variable Municipal Term Preferred (VMTPs): These are a cross between VRDPs and MTPs- they generally have a three year term and variable financing rate.
- Tender Option Bonds (TOBs): A CEF transfers a highly-rated municipal bond to a trust sponsored by a broker-dealer and receives an inverse floater in return. The trust issues floating rate securities that reset each week based on an index of high grade seven-day demand notes. These securities are money-market eligible and may be bought by other investors and tendered at par. The CEF earns the interest from the transferred bond minus fees plus the interest paid to the holders of the floaters.
- Municipal Term Preferred (MTPs): Fixed rate preferred stock with a mandatory redemption period of five years. Some MTPs can be called at par at anytime. Closed-end funds that issue MTPs are required to have asset coverage of at least 225% of the value of the MTPs, which allows them to have a high AAA rating. Existing MTPs generally have coupons in the 2% to 3% range.
The CEFs that have replaced ARP financing with the newer forms of leverage have lower earnings than before which leads to lower sustainable dividends.
The Invesco VK Advantage Municipal Income Trust II Fund (VKI) is a leveraged national municipal bond fund. It buys tax exempt municipal bonds that are investment-grade (at the time of investment).
Factor #1: What is the distribution rate?
VKI currently has a high distribution yield of 6.68%. It pays a regular monthly dividend of $0.073 per share or an annual distribution of $0.876.
Factor #2: What is the likelihood the fund can raise its monthly dividend?
To determine this, I look at the Average Earnings/Current Dividend Ratio. This ratio tells you whether or not a fund is earning its current dividend. If the value is well above 100%, it means the fund can easily afford to raise its distribution rate.
For VKI, the average earnings for January, 2012 was $0.065, so the latest Average Earnings/Current Dividend ratio= 89.0%.
This factor is negative, since VKI did not earn its last distribution. But there is a large positive value for "Undistributed Net Investment Income" or UNII Balance of +0.260, which means that VKI has nearly four months of interest in reserve which can cover future monthly shortfalls for some time.
Factor #3: What is the Expense Ratio?
I look at the Baseline expense ratio which does not include leverage costs. VKI has a baseline expense ratio of 1.09% which is about average.
Factor #4: What is the discount to NAV?
VKI is currently selling at a +3.55% premium over NAV. The 6 month average premium is 1.33%. The one year Z statistic is +1.94. So on a one year basis, the premium is nearly two standard deviations above average. Overall, this factor is a negative for VKI. I would recommend placing VKI on a watch list and try to buy it when the premium is 1% or less or better yet, trading at a discount to net asset value.
Factor #5: How much leverage is used, and what is the borrowing cost?
As of December 2011, VKI used 40% effective leverage including ARP financing and TOB assets. This is the asset breakdown in January 2012-
Total Assets $945.3 Million
ARP Financing $231 Million
TOB Financing $148.15 Million
VKI has very low borrowing costs of around 0.27% on their ARP financing, and about 1.30% on the TOB financing.
Factor #6: What is the AMT exposure?
As of 01/31/2012, VKI had 16.83% in bonds subject to AMT.
Factor #7: What is the credit quality?
I look at the breakdown of AAA, AA, A, BBB, Below BBB & Unrated.
This is the S&P ratings breakdown for VKI as of 1/31/2012:
|BB & below||12.01%||Includes unrated.|
VKI is a medium risk fund with an average credit rating around A.
Factor #8: What is the interest rate exposure?
VKI has an option-adjusted duration of 9.02. This is about average. I prefer funds with an average duration of 10.0 or less.
Factor #9: What is the call exposure?
Here is a table with the call dates for bonds in VKI:
VKI has moderate call risk over the next few years if interest rates fall much further. The average coupon rate of its bonds is 5.64%. Given the high level of the UNII balance, there is only limited short term risk to the monthly dividend.
Factor #10: For a national fund, what is the breakdown by state?
Factor #11: How good is the trading liquidity?
VKI has an average daily volume of 65,000 shares, and an average dollar volume of $0.776 million. It is relatively easy to buy small positions, but more difficult to trade larger lot sizes.
Factor #12: What percent of the portfolio is in Housing-Multifamily bonds?
Given the shaky housing market, I like to avoid funds where the Housing Multi-Family sector is above 10%. VKI has only 1.96% in single family housing and 0.32% in multi-family.
Factor #13: Fund Management
VKI is managed by Thomas Byron, Robert Wimmel and Robert Stryker, who all came from Van Kampen.
Factor #14: Other Analyst Coverage
VKI is covered by the Merrill Lynch closed-end fund team and is currently rated as a Buy.
Based on the above 14 factors, I am currently neutral on VKI. It is an attractive fund because of its low leverage costs. But the ARP financing is gradually being replaced with other higher cost forms of leverage. But I would consider a purchase of VKI if/when it ever sells at a discount to net asset value.
Disclosure: I am long NPM.