Despite Narrowing Of Relative Valuation, One National Muni Fund Is Still Better Than The Other

Summary

• An arbitrage trade between the national muni funds was proposed.
• The trade moved in our favor, although in this case borrow fees were too much to overcome.
• On a standalone basis, one of the funds is still better than the other.

Author's note: This article was released early to members of the Cambridge Income Laboratory.

A municipal [muni] bond is a debt security issued by a state, municipality or county to fund its capital expenditures, such as the building of highways, bridges or schools. Muni bonds are exempt from federal taxes and from most state and local taxes, making them especially attractive to people in high income tax brackets. This arbitrage trade deals with two national muni closed-end funds [CEFs].

• Short: DWS Municipal Income Trust (NYSE:KTF): 6.21% yield, +8.04% premium, +2.00 z-score, 36.37% leverage, 1.40% expense ratio.
• Long: Pioneer Municipal High Income Advantage Trust (NYSE:MAV): 5.10% yield, -2.20, -4.94% discount, 33.05% leverage, 1.21% expense ratio.

A divergence has opened up between the CEFs. Both funds are national muni funds, though it should be noted that MAV contains a significant amount of non-investment grade and non-rated debt (40.0%), whereas the portfolio of KTF is 97% investment grade. KTF has a 4 star rating from Morningstar while MAV is rated 5 stars, though I do not put much stock into those ratings.

Over the past 1 year, KTF has a price return of +6.66%, beating MAV (-13.17%) by some 20 percentage points.

However, much of this has been due to KTF's expanding premium:

(Source: CEFConnect, KTF)

In fact, KTF's current premium of +8.04% has only been reached a few times over the past 18 years, and you have to go back to 1998 (!) before we see premia in excess of 10%.

(Source: CEFConnect, KTF)

In contrast, the premium/discount of MAV has fallen onto hard times, falling from nearly 12% last year to its present value of -4.94%.

(Source: CEFConnect, MAV)

Notably, MAV was trading at significant premia until recently. Only in 2008 did its discount exceed -10%.

(Source: CEFConnect, MAV)

What has caused this tremendous discrepancy? My guess is to do with distribution policy. Over the past several years, MAV has had to cut its distribution several times. In fact, as recently as two years ago, MAV was yielding a whopping 9.5% on NAV (about 7.3% on price), which was clearly unsustainable, especially as higher-yielding paper matured and were replaced with lower-yielding debt. This high yield was probably the reason why MAV's premium was bid into the low 20's in 2014.

(Source: CEFConnect, MAV)

In contrast, KTF has maintained a very steady or increasing distribution since about 2006, and even managed to squeeze out a small special distribution this past Christmas.

(Source: CEFConnect, KTF)

My personal view is that distribution policy does not affect the intrinsic value of a company (Modigliani-Miller theorem). In fact, MAV has actually outperformed KTF on a NAV basis over 1-, 3- and 5-year time frames, and only trails over 10 years.

(Source: Stanford Chemist, Morningstar)

What kind of gains are we looking for here? If KTF's current premium of +8.04% were to contract to its 52-week average of +3.99%, the short side could gain about 4 percentage points of alpha. On the other hand, if MAV's current discount of -4.94% were to contract to its 52-week average of -5.49%, a further about 10 percentage points of alpha could be available. I should note that with MAV's distribution being reduced to a lower and more conservative level, the stock may not recover its historical premium due to its lower attractiveness to income investors. Still, the temporary price dislocation due to investors selling the CEF on news of a distribution cut may still yield a favorable result.

At the time of writing, Interactive Brokers currently shows that 75K shares of KTF are available for shorting at a fee of 13.68%.

[Jul. 6, 2017 update] Since initial publication, MAV (+6.95%) has outperformed KTF (+3.11%) by 3.84 percentage points (about 10% annualized), equivalent to about 7.5 month's worth of distribution from KTF. Unfortunately, the high borrow fees of KTF ate up all of our profit, and the overall profit/loss on this trade was -1.18%. However, it should still be noted that someone who was already owning KTF could have benefited fully from the swap to MAV without paying any short fees.

MAV Total Return Price data by YCharts

During this time, KTF's premium has contracted slightly from +8.04% to 7.75%, while MAV's discount has contracted from -4.94% to -2.42%. In other words, both sides of the trade moved in our favor, at least as far as premium/discount is concerned.

MAV Discount or Premium to NAV data by YCharts

It should also be noted that MAV also outperformed KTF on a NAV basis during this time.

MAV Net Asset Value data by YCharts

KTF's 1-year z-score has also fallen from +2.00 to +1.20, while MAV's has risen from -2.20 to -0.30. This suggests that the potential for arbitrage has largely subsided. However, on a standalone basis, which fund would I prefer to own? The answer is still MAV, for the following reasons:

• MAV's discount of -2.42% is over 10 percentage points lower than KTF's.
• MAV has had stronger historical performance (by NAV) over 3- and 5-year periods compared to KTF.
• Despite MAV's higher concentration in non-investment grade municipal holdings, the government-backed nature of the debt makes it more palatable, in my opinion, than corporate junk bonds. Moreover, looking at the latest annual report, MAV only has ~2% of its holdings in Illinois and ~1% in Puerto Rico, two junk or near-junky states.
• Due to its past distribution cuts, MAV a lower current yield (5.14%) than KTF (6.17%). While this might be seen as a negative, it actually allows MAV more stability in NAV as well as the potential to increase the distributions when the time is right. As a case in point, MAV actually bumped up its dividend by about 5% (from $0.0475 to $0.0500) two months ago.
• Related to the point above, the lower yield of MAV means that it has a better coverage ratio than KTF. According to CEFConnect (which draws from the fund's latest annual/semi-annual reports), MAV has a coverage ratio of 1.12, whereas KTF's coverage ratio is only 0.88, as calculated using the present distribution rate. This indicates that out of the two funds, MAV is the only one that is earning its distribution.

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Analyst’s Disclosure: I am/we are long MAV. 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.