Ok, you’ve dealt with your taxes and you’re still feeling the sting. This is the time of year many of us start thinking more closely about tax efficiency. For the income investor there is no more tax-efficient source than tax-exempt municipal bonds. This is, of course, a major area for closed-end funds.
Muni-bond CEFS enjoy multiple advantages. One such is that their leverage can be sold cheaply because under some circumstances it offers tax-free income to the lender. Furthermore, despite occasional headline-grabbing municipal defaults, municipal bonds are among the safest of investments as we see in this comparison of municipal and corporate bond defaults from Moody’s.
Muni-bond yields are low, but for high-bracket investors the tax-equivalent yields of municipal bond CEFs can approach those of leveraged high-yield bond funds as shown in this table.
Many high-bracket investors have income that is subject to alternative minimum taxes or AMT. Unfortunately, not all municipal bonds have the same AMT status. The funds may be invested in private activity bonds, which are issued to fund stadiums, hospitals, housing projects and the like. While these are not subject to ordinary income taxes, they (and that portion of a fund's income that originates from those sources) are subject to AMT. These private activity bonds do carry a higher yield than AMT-free bonds, but depending on one’s tax situation it may not be sufficient to overcome the AMT hit.
With this in mind I want to take a look at AMT-free municipal-bond CEFS, which are completely exempt from federal taxes. This information is surprisingly opaque. Cefconnect has a category for AMT liability on their CEF screener, but it turns up exactly one fund if you set it to zero. Oddly, it doesn't even return funds that have AMT-Free in their names including the three Nuveen funds which is especially awkward as Nuveen is the sponsor of cefconnect. So I’ve compiled a list of fourteen AMT-free municipal bond CEFs for reference. I’ve checked the list against the sponsors’ websites and I am confident that each of these is fully AMT-free. There may be others that I have missed, so if you have a favorite not included please let me know so I can revise this list.
AMT-Free Municipal Bond CEFs
BlackRock Municipal Income Investment Quality Trust (BAF)
BlackRock Municipal Income Investment Trust (BBF)
BlackRock Municipal Income Quality Trust (BYM)
Eaton Vance Municipal Bond Fund (EIM)
Eaton Vance Municipal Bond Fund II (EIV)
Federated Premier Intermediate Municipal Income Fund (FPT)
Federated Premier Municipal Income Fund (FMN)
Managed Duration Investment Grade Municipal Fund (MZF)
Nuveen AMT-Free Municipal Income Fund (NEA)
Nuveen AMT-Free Municipal Credit Income Fund (NVG)
Nuveen AMT-Free Municipal Value Fund (NUW)
PIMCO Municipal Income Fund (PMF)
PIMCO Municipal Income Fund II (PML)
PIMCO Municipal Income Fund III (PMX)
Here are some current key metrics for these funds. I’ll start with distributions. You can refer to the first table to see what your tax-equivalent yield would be for these funds.
As we see yields top out just above 6% (PML) in today’s market. This is low relative to past levels of muni-bond CEF yield, but such is the state of the income market. The extended period of low interest has caught up with muni-bond fund holdings and funds have been cutting their distributions on a regular basis. Some wait and take large cuts. Others slice away at their distributions every few months. But cuts are the order of the day in muni-bonds. One one to deal with this is to time purchases after a fund has cut distributions because those that haven't will likely be doing so shortly.
As I noted above a key advantage for muni-bond CEFs is their access to exceptionally cheap leverage. All but one of these funds (NUW) carries over 35% leverage, a range that is typical of the entire muni-bond CEF universe.
Premiums and Discounts
Nine of the funds carry discounts, ranging as deep as -8.54% (NEA), and five are priced at a premium (the three PIMCO funds, BBF and NUW, which has a trivial premium of 0.12% at the time of this writing).
NAV Yield and Discount Status
Regular readers will be aware that I like to use a plot of Premium/Discount vs. NAV Yield (the PDNY chart) as a tool to identify possible well-valued CEFs. I’ll not discuss it in detail here beyond noting that within CEF categories there tends to be a strong positive correlation between NAV yield and Premium/Discount as yield-focused investors tend to bid up high yielders and bid down low yielders. This chart shows the PDNY relationship for the fourteen AMT-free muni-bond CEFs.
This is something of an atypical pattern in this chart with a near-flat to slightly negative correlation below 5.5% NAV yield and the upward slope of the correlation being driven by a handful of funds selling at a premium.
This chart is only an overview, there are distinct difference among the funds and their portfolios that account for the differences in NAV yields and the tendencies to P/D valuations, so not too much should be made of it. It does tend to highlight better values, however. NVG and the two BlackRock funds (BAF and BYM) look attractive here. But that’s only a first cut that tells us nothing more than those two funds should be worth a close look. The PIMCO funds show the usual PIMCO premium, which reflects the exceptional yields PIMCO is able to generate from the same universe of bonds available to every fund manager.
I’ve not examined the portfolios of these funds in any detail as my objective here is only to provide a list of AMT-free funds as a starting place for interested readers to begin their own researches. Such key metrics as portfolio duration and portfolio credit quality will certainly have to be examined before anyone can make choices from this lot.
However, as a starting place let me point out those three PIMCO funds. They are priced at a premium as we see. While I tend to avoid funds at a premium, it’s not hard to argue that PIMCO funds merit their premium valuations much the same as high-yielding preferred stock or even bonds from quality companies can merit premium valuations, and for much the same reasons. The market may well take back those premiums at some point but, unlike preferreds or bonds, at least they’re not going to be called away from you at par. Not a bad deal when you consider that the 5.3% to 6% the PIMCOs are paying is completely exempt from federal taxes. Can you do as well with preferred stock from quality issuers or investment-grade bonds?
Disclosure: I am/we are long EIM NVG.
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.
Additional disclosure: I remind readers that this article does not constitute investment advice. I am passing along the results of my research on the subject. Any investor who finds these results intriguing will certainly want to do all due diligence to determine if any fund mentioned here is suitable for his or her portfolio.