CEF Arbitrage: Munis, Again

| About: Delaware Investments (VMM)
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Summary

Two Minnesota muni CEFs, one from Nuveen and the other from Delware Investments.

One was at a 13.80% premium, and the other was at a -7.19% discount.

A natural CEF arbitrage opportunity presented itself.

This article was released to members of the Cambridge Income Laboratory two weeks ago.

During my research into overvalued and undervalued CEFs, I noticed an interesting pair of Minnesota muni bond funds, one run by Nuveen and the other by Delaware Investments:

  • Nuveen Minnesota Municipal Income Fund (NYSE:NMS): 4.72% yield, +13.80% premium, +2.00 1-year z-score, 37.53% leverage, 1.73% expense ratio.
  • Delaware Investments Minnesota Municipal Income Fund II (NYSEMKT:VMM): 4.24% yield, -7.19% discount, -0.60 1-year z-score, 30.22% leverage, 1.42% expense ratio.

These two funds are the only two Minnesota bond funds in the CEF database of CEFConnect. Intriguingly, one trades at a +13.80% discount (+2.00 1-year z-score), while the other trades at a -7.19% discount (-0.60 z-score), an over 20% differential. As we have recently seen with the PIMCO Municipal Income Fund (NYSE:PMF) and the Invesco Value Municipal Income Trust (NYSE:IIM), two national muni CEFs, quick profits can be had when premium/discount values revert.

The fact that both NMS and VMM are Minnesota funds lowers the risk of this pairs trade, as we don't have to worry about state-specific effects. VMM appears to have a slightly higher quality portfolio (83% investment grade holdings) versus NMS (77% investment grade), but the two funds appear to be quite similar in most respects.

NMS Total Return Price Chart

Over the longer term NMS has recorded higher returns, with about 1% extra per year over 15 years. Although does this justify a 20% differential in premium/discount value, not to mention the alpha that NMS holders are losing (and VMM holders gaining) by the very fact that distributions are being made at a premium for NMS (and discount for VMM)?

(Source: Stanford Chemist with data from Morningstar, performance figures above 1-year are annualized)

Over the past 6 months, VMM's discount has been on a downward trajectory:

(Source: Stanford Chemist with data from CEFConnect)

In comparison, NMS's premium has risen to 52-week highs:

(Source: Stanford Chemist with data from CEFConnect)

The thrust of this difference is that while both NMS and VMM have exhibited nearly identical (and flat) NAV performances over the past 6 months, NMS has seen a price increase while VMM's price has gone down.

(Source: Stanford Chemist with data from CEFConnect)

Part of this discrepancy might be due to negative sentiment regarding VMM, which recently cut its monthly distribution by about 10%, from $0.0525 to $0.0475. Meanwhile NMS's distribution has held steady at $0.0665 per month for the last 12 months.

A contraction of VMM's discount from -7.19% to its 1-year average of -4.72% would net about 2.5 percentage points in alpha, whereas over 10 percentage points of alpha could theoretically be gained if NMS' premium of 13.80% reverted to its 1-year average of 2.25%. Thus, I would recommend anyone owning NMS to swap into VMM, while more adventurous individuals may consider a long VMM/short NMS pairs trade.

[Dec. 2nd update] NMS's premium has contracted from +13.80% to +10.47% over past two weeks. At the same time, VMS's discount has contracted from -7.19% at the time of writing to -4.26% today. In other words, both sides of the trade moved in our favor, at least in terms of premium/discount reversion. An investor who swapped from NMS to VMS as I suggested would have saved 6.71% over this time period, equivalent to gaining over 1 year's worth of distributions from NMS just over two weeks!

NMS Total Return Price Chart

As NMS's premium is still significantly higher than its 1-year average of +3.20% (1-year z-score = +1.20), there might still be room for this trade to run. However, note that VMM's discount is now slightly narrower than its 1-year average of -4.53% (1-year z-score = +0.10).

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.