Muni CEFs Revisited: Feeling Lucky?

by: Joe Eqcome

In the tradition of “I’d rather be lucky than good”, on October 5th, 2008, I penned an article entitled, “CEF Muni Price Relationship with Muni Spread Highlights Current Wide Divergence—LEO, KTF, MVG. While I didn’t catch the “top tick”, the spread between Bond Buyer GO 20-Year Bond Municipal Bond Index and 20-year Treasury Constant Maturity peaked two months later in December of ’08 at 2.4% (see graph below).

The three stock picks mentioned in the title of that article on average are up 33.7%. This is versus 22.8% for the First Trust Municipal Closed-End Fund Price Index and 7.4% for the iShares S&P National AMT-Free Muni Bond Fund (NYSEARCA:MUB) ETF.

Feeling Lucky? Clint Eastwood, as Harry Callahan in the movie “Dirty Harry”, asked a hapless criminal he confronted to consider a rhetorical question. The question was regarding whether Harry had fired six shots or only five from his .44 Magnum. This in turn was related to a pending decision by the suspect as to the advisability of “making a break for it” based on this imperfect information. The question Harry posed was, “Do I [you] feel lucky?”

Feeling Lucky: Well, in the case of muni CEFs, we may have only fired five shots and there may be one more bullet left in the barrel. The following are the reasons for taking this investment posture:

1. The current pretax yield on the CEFMuni10 (see table below) is 6.24% with a taxable equivalent yield of 9.6% (35% federal tax rate);

2. While the muni spread has narrowed from its peak of 2.4% in Oct of ’08, on average the current spread is still 0.5% above its average since 1993 (see chart accompanying graph);

3. The inevitability of rising tax rates which will likely drive more income-oriented buyers to tax-exempt investments which may drive up their value;

4. The reduction of tax-exempt muni bond supply as the Build America Bonds, interest rates subsidized by the Federal government, replace new, tax-exempt muni issues.

CEF Muni Portfolio: Below is a list of NatlMuniBndFnds that make up the Eqcome CEFMuni10. This is a companion list to the CEFBig10[2].

The CEFMuni10 is a list of the 10 largest CEFs that own a diversified portfolio of multi-state municipal bond obligations with less than 40% leverage and total assets of over $900 million. The CEFMuni10 provides retail investors a self-directed, easy and inexpensive way to own a diversified portfolio of municipal investments with some degree of liquidity.
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CEF versus ETF Comparisons: The average of CEFMuni10 is compared against the iShares S&P National AMT-Free Muni Bond (MUB) ETF. The distribution yield for the CEFMuni10 is 72.9% higher than the ETF (6.24% versus 3.61%, respectively). Despite its lower distribution yield, MUB is also trading at a 10% premium versus the CEFMuni10 trading at par.

Greater Leverage and Expense Ratio: MUB’s lower yield and premium valuation is attributable to the greater risk of leverage employed by the CEFs versus no leverage for the ETF (MUB). Also, the CEFMuni10 average total expense ratio is 1.32% versus 0.25% for the ETF.

Risk/Reward Equation: So, on average there are clear trade-offs between the CEFMuni10 averages and the muni ETF (MUB). CEFs have more risk and the potential for greater reward.

Greater Volatility: The graph below is a comparison of the adjusted stock price (for distributions and splits) of the CEFMuni10 price performance (“blue”) versus the MUB (“pink”). The third line (“green”) is that of First Trust Municipal Closed-End Fund Price Index (MNCEF). As the chart demonstrates, the CEFs on average are more volatile as retail investors have a tendency to “panic” in a stock market slump.

Caveats: There can be no question that states’ budgets are under a great stress and strain. This increases the risk of a default on muni obligations — particularly, if it is not a general obligation of the taxing authority.

Another potential risk is the leverage employed by the CEFs. An increase in the cost of borrowing may result in lower future distributions as well as a diminished value of the fixed-income investment portfolios.

Adequate Reward: However, even if there are some defaults in the portfolios, it appears that the risk is already priced into the stock; you’re adequately being paid for that risk.

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Compared with high-yield (junk) bonds whose risk seemed so much greater than that of munis, junk bond prices soared over the past twelve months.

It just appears on the face of it that the risk seems manageable for the CEFMuni10.

Disclosure: Author long stocks in the CEFMuni10