Levered Municipal Closed End Funds: A Dislocation Of Price And Value

by: Income Samurai

About two months ago I wrote two articles (Levered Municipal Closed End Funds: A Cautionary Tale and 4 Strategies For Increasing Yield And 11 CEFs That Will Help You Profit), detailing my opinion of Leveraged Municipal Closed End Funds (LMCEFs) and some potential opportunities in Taxable Credit sectors of the fixed income market. With a long history of working directly with individual retail investors, I felt it was my duty to alert investors. In the following paragraphs, I will give a brief update on the results of these recommendations and my current opinion.

Closed End Funds (CEFs) are an interesting investment vehicle due to their unique characteristics. CEFs trade in the open market in a similar fashion to stocks, but rarely trade at their Net Asset Value ((NYSE:NAV)) as open-ended mutual funds do. Many closed end funds use investment techniques like leverage (borrowing money to buy more securities) to enhance their yield. The use of leverage increases the intensity of price fluctuations in exchange for higher income. I have found the majority of CEF investors to be risk averse and invest for the purpose of receiving income.

Many of these investors will tell you that they invest for income and are unfazed by the volatility in their portfolio value. Security pricing and volume tells us a different story. Over the past few days, we have seen dramatic trade volume increases and significant price declines. In the CEF market, we often see selling lead to more selling and buying lead to more buying. Because the CEF market is dominated by retail investors, dramatic price movements are not uncommon. Currently, I believe we are witnessing a dislocation between price and value in LMCEFs. Investors are increasingly concerned about future interest rates and the upcoming election, as a possible explanation for the swift decline in the value of their CEF holdings.

Over the last several months, investors have been unconcerned with inflation or the potential of rising interest rates. The Federal Reserve has been unusually vocal about future interest rate increases, aiming at 2014 for an initial increase. Many investors have bet that The Fed will institute another round of Quantitative Easing (QE3) and continue intervention efforts, keeping long-term interest rates low.

Based on the historical spread between Municipal Bonds and U.S. Government bonds, Munis seem to be a largely underpriced. Most investors and analysts fail to relate Muni and Treasury yields compared to their long term average. Many feel the Fed is able to keep interest rates low across the yield curve, a huge fallacy. The Fed controls short term interest rates through policy and attempts to control intermediate and long term rates through open market transactions. Currently, U.S. Government debt is about $15.5 trillion, and the Fed's balance sheet is about $3 trillion. The Fed can control 20% of the U.S. Government debt, which leaves about 80% subject to the open market.

After a significant rally in risky assets, specifically stocks, investors are anticipating higher interest rates and increased inflation. Bond returns have been impressive during the wild volatility experienced by stocks over the past 5 years. The investment community has witnessed repeated record inflows to bond mutual funds, while equity mutual funds have shown consistent withdrawals.

Personally, I believe that the stock market has gotten a little frothy and may be nearing a top. In about 4 weeks, we will begin hearing first quarter earnings reports with some new financial information to digest. This can be a catalyst for future gains, have a stagnating effect ,or cause investors to take profits and send the stock market lower. I personally believe that the recent stock market rally is a bit late and should have occurred during the final quarter of 2011.

With earnings season nearing, we will see how corporations fared during a quarter of significant changes to energy prices, exchange rates and commodity prices. I have personally been taking some gains in large company stocks, specifically in areas that I consider to be overbought: Utilities, Consumer Staples and Healthcare. I have yet to reinvest the proceeds and am keeping my cash allocation higher in anticipation of future opportunities.

In my previous two articles, I considered LMCEFs to be overvalued and taxable credit sensitive CEFs were undervalued. After publishing these articles, initially I was dead wrong with my LMCEF prognostication; they continued to rally for several weeks. It was the events of the past week that has exemplified the unique behavior of LMCEF investors. I believe we are again witnessing a dislocation between price and value.

While updating my two CEF lists, I noticed some unusual behavior. On average, the movement between price and NAV has been almost identical for the taxable credit CEFs, while there is a great dispersion between the LMCEFs price and NAV. Since publishing, the average NAV for the LMCEFs has returned -.51%, while the prices have returned -4.26%. This -3.75% of disparity is causing me to reexamine this investment.

Based on the behavior tendencies of investors, disparities and irrational behavior can persist. Although I feel LMCEFs are oversold, I am not at to the point where I am willing to reallocate and buy heavily. At this time I am carefully examining some individual LMCEFs and looking to take some strategic positions. I would be extremely careful of attempting to time this opportunity perfectly, since it is very dangerous to "catch a falling knife." I will reiterate that this asset class is dominated by retail investors who sell on panic and buy on euphoria.

Overall, I still remain confident in allocating resources to taxable credits and away from municipal and U.S. Government issued bonds. I would continue to focus on the expected total return (price change and income received) of an investment, rather than based solely on its current yield or tax-exempt status. I will continue to monitor the situation and follow up with further actionable recommendations. For now, I would sit tight for a little while and see how the situation unfolds.

Current Closing Price NAV
Ticker Fund Name Distro Rate Prem/Disc 1/16/2012 3/16/2012 %Change 1/16/2012 3/16/2012 %Change
BFK BlackRock Municipal Income 6.84% -0.92% $14.61 $14.06 -3.76% $14.17 $14.19 0.14%
BLE BlackRock Municipal Income II 6.77% -2.05% $15.38 $14.81 -3.71% $15.11 $15.12 0.07%
DSM Dreyfus Strategic Muni Bond 6.83% -2.00% $8.72 $8.35 -4.24% $8.56 $8.52 -0.47%
IIM Invesco Insured Muni Income 5.80% -2.76% $17.12 $15.52 -9.35% $16.16 $15.96 -1.24%
KTF DWS Municipal Income 6.52% -2.64% $13.74 $12.89 -6.19% $13.41 $13.24 -1.27%
LEO Dreyfus Strategic Municipals 6.80% -1.14% $9.08 $8.65 -4.74% $8.82 $8.75 -0.79%
MMU Western Asset Managed Muni 6.01% -4.92% $13.75 $12.98 -5.60% $13.66 $13.65 -0.07%
MUE BlackRock MuniHoldings Qty II 6.53% -5.86% $14.48 $13.50 -6.77% $14.48 $14.34 -0.97%
MVF BlackRock MuniVest 7.03% -0.69% $10.42 $10.07 -3.36% $10.18 $10.14 -0.39%
MVT BlackRock MuniVest Fund II 6.93% 1.29% $16.15 $15.75 -2.48% $15.59 $15.55 -0.26%
MYD BlackRock MuniYield 6.88% -2.08% $14.98 $14.57 -2.74% $14.89 $14.88 -0.07%
NIF Nuveen Premier Municipal Opp 6.19% -4.63% $16.21 $14.64 -9.69% $15.46 $15.35 -0.71%
NQS Nuveen Select Quality Muni 7.08% -3.12% $15.33 $14.58 -4.89% $15.09 $15.05 -0.27%
PMF PIMCO Municipal Income 6.93% 11.15% $14.70 $14.06 -4.35% $12.63 $12.65 0.16%
PML PIMCO Municipal Income II 6.69% 1.48% $11.84 $11.66 -1.52% $11.44 $11.49 0.44%
PMX PIMCO Municipal Income III 7.34% 10.95% $11.67 $11.45 -1.89% $10.35 $10.32 -0.29%
VGM Invesco VK Muni Invst. Grade T 7.27% -0.27% $14.98 $14.53 -3.00% $14.73 $14.57 -1.09%
VKI Invesco VK Adv Muni Inc II 7.04% -0.40% $12.70 $12.44 -2.05% $12.63 $12.49 -1.11%
VKQ Invesco VK Municipal Trust 6.97% -1.22% $14.21 $13.78 -3.03% $14.08 $13.95 -0.92%
VMO Invesco VK Muni Opps. Trust 7.30% 1.65% $14.40 $14.14 -1.81% $14.05 $13.91 -1.00%
Average 6.79% -0.41% Average -4.26% Average -0.51%
Current Closing Price NAV
Ticker Fund Name Distro Rate Prem/Disc 1/26/2012 3/16/2012 %Change 1/26/2012 3/16/2012 %Change
AVK Advent Claymore Conv & Income 6.85% -6.85% $16.16 $16.46 1.86% $17.41 $17.67 1.49%
BPP BlackRock Credit Alloc III 6.85% -10.02% $10.97 $11.13 1.46% $12.05 $12.37 2.66%
DHG DWS High Income Opportunities 8.38% 0.83% $14.54 $15.76 8.39% $15.36 $15.63 1.76%
FAM First Trust/Aberdeen Global 9.07% -2.60% $16.65 $17.20 3.30% $17.35 $17.66 1.79%
FSD First Trust High Inc Long/Shrt 8.86% -2.22% $16.68 $18.09 8.45% $17.82 $18.50 3.82%
GDO Western Asset Glb Corp Def Opp 8.03% -3.83% $18.92 $19.06 0.74% $18.99 $19.82 4.37%
JFR Nuveen Floating Rate Income 7.12% -2.45% $11.42 $11.54 1.05% $11.59 $11.83 2.07%
JHP Nuveen Quality Preferred Inc 3 7.55% -2.01% $8.24 $8.27 0.36% $8.12 $8.44 3.94%
PPR ING Prime Rate Trust 6.39% -2.76% $5.51 $5.63 2.18% $5.72 $5.79 1.22%
PSF Cohen & Steers Select Pref&Inc 8.51% -0.94% $23.66 $24.26 2.54% $23.36 $24.49 4.84%
PSY BlackRock Credit Alloc II 7.08% -10.17% $10.27 $10.34 0.68% $11.26 $11.51 2.22%
Average 7.70% -3.91% Average 2.82% Average 2.74%
Difference 7.08% Difference 3.25%
*Price and NAV change are calculated on an absolute basis and does not reflect income received.
**Information courtesy of CEFconnect.com

Disclosure: I am long GDO, FAM, JHP.