While we don't see the "sky falling" for the muni CEFs, we believe there is a case building that we may be at "peak" valuations for this fund type. We urge investors to be cautious and selective in committing additional capital to this CEF fund type.
EV NY Municipal Bond (ENX) and EV Municipal Bond II (EIV) along with PCK PIMCO CA Muni Income II seem to have the largest potential price decline if their share prices were to gravitate towards their 5 year average premium (see table below).
The Good News: Muni CEFs were the best performing CEF sector in 2011. NatlMuniBndFnds average price appreciation was up 12.5% and SingleStMuniFnds was up 11.8%. This was before you tacked-on an average pre-tax yield of around 6.0%.This was in comparison to an average share price decline of 3.6% for the 13 CEF fund types we monitor.
Our Concerns: There are several areas of concern relating to the attractiveness of CEF Munis that we believe deserve closer scrutiny at this juncture.
Sector Rotation: The 13 CEF fund types are notorious for their relative price appreciation ranking to churn year-from-year. Since 2004, no CEF fund type experienced the highest annual ranking consecutively. So, investors may not want to purchase the highest ranked CEF fund type in the subsequent year. (See "What Color is Your CEF?" August 15, 2011, where we color-coded the annual rankings for purpose of illustration.)
Valuation: The adjacent chart is a comparison of the average premium/discount of CEF muni funds compared to the CEF fund sector as a whole. In the chart the "green" line represents the average premium discount for the muni CEFs versus the "black" line for all the CEFs.
Hitting a Ceiling: The first thing to note is that anytime the muni CEF premium breached par the fund type subsequently experienced a sustained downturn. This occurred in 1990, 1998 and 2009. We are now again seeing this evidence as the average premium for muni CEFs is 1.3%.
We have also calculated the monthly premium/discount spread between the two. The same chart illustrates ("red" line) that anytime the spread bumps up against the 5.0% level it has a tendency to encounter resistance. This metric appears as an early indicator to the breach of par. On both counts we're seeing the group trade close to perfection.
Lagging Municipality Economics: State and local governments still face fiscal challenges. The easier cuts and adjustments to state and local budgets have already been made.
States will need to close a combined budget gap of $40 billion in fiscal 2013, according to the Pew Center on the States, a nonprofit, nonpartisan research institution. The good news is that it is down substantially from $174 billion in fiscal 2010.
However, while tax receipts have increased for many states as the economy continues its stubborn recovery, tax revenues are still below pre-recession levels, federal aid continues to fall and unemployment remains stubbornly high. Off-setting some of that increase in revenues is the surging cost of health care and pensions which will be hard to change given the embedded constituencies.
While municipal defaults will remain muted, it does raise the prospect of credit-rating downgrades and lower bond valuations.
Sustainability of the Distributions: We also noted that 5 of the 10 Nuveen unleveraged muni funds reduced their distribution this month.
Unwinding of LeverageIn our database of 622 CEFs, 236 are coded as either NatlMuniBndFnds or SingleStMuniFnds. The average leverage for the muni group is 32.2%. Based upon a 5.0% average coupon for muni debt held in their portfolios, a 1.5% expense ratio and a debt cost of less than 1%, the return on CEF muni equity would be approximately 5%. This is very close to the current distribution average yield.
If you were to raise the cost of debt 1%, the return on equity, and presumably, the distribution yield would decline by approximately 10%.
Unusual Suspects: We performed a scan on our data base to generate those muni CEFs that were trading at over a 10% premium. We then compared the current premium with their 5 year average to generate the share price change if the share prices were to gravitate towards the 5 year average. We sorted them on that basis.
The average decline was 4.8%. This on the face of it doesn't seem disastrous. However, if rates were to rise there would be additional downside pressure on both distributions and valuations.
EV NY Municipal Bond and EV Municipal Bond II along with PCK PIMCO CA Muni Income II seem to have the largest potential price decline if their share prices were to gravitate towards their 5 year average premium.