Build America Bonds: The Impact Of Yield Chasing

| About: BlackRock Build (BBN)

Summary

Yield-seeking investors have pushed up prices of Build America Bond funds, a special class of taxable municipal bonds.

High yields come with risks from reduced net asset value discount, duration risk.

Distribution yield is much higher than yield to maturity.

Introduction

In this market, investors have been chasing yields. In this article, I explain how this has led to an increase in price, decrease in yield, and decrease in net asset value, or NAV, discount for several closed-end bond mutual funds. I focus on a subset of taxable municipal bond funds, as these types of funds are high in yield, have generally low credit risk, and thus are not affected by changes in credit market sentiment. Furthermore, these bond funds have been largely marketed and held by individual investors rather than institutional investors.

While these funds may seem attractive due to their high yields, new investors should be aware of potential price risks due to low NAV discount and the built-in price decline due to the component bonds being priced at a premium to par.

Taxable Municipal Bonds

There is a little-known corner of the municipal bond world where some issuers offer taxable bonds. These are mostly the Build America Bonds (“BAB”), which were created as part of the 2009 American Recovery and Reinvestment Act. Unlike other municipal bonds, the 2009 ARRA allowed municipal entities to issue bonds that had taxable yields, either as a direct subsidy from the Treasury, or as a refundable tax credit. The purpose of this was to subsidize the cost of borrowing for municipal investments that would not otherwise have been funded with traditional tax-free municipal bonds. These bonds were issued between 2009 and 2010. When the program expired, $181 billion of BABs had been issued, comprising less than 5% of the $3.8 trillion municipal bond market.

For investors, the appeal of these bonds is the relatively high yield, compared to other municipal bonds; the credit quality of municipal issuers; and the payment support from either the direct payment or tax credit. Many bonds were issued with coupons in the 6% to 7% range for 20-30 year maturities. Several mutual fund companies saw the appeal of this and packaged these bonds into closed-end mutual funds which specialize in the BABs. Four that I have found (with prices and yields as of July 14, 2017) include:

  • BlackRock Taxable Municipal Bond Trust (BBN), $23.16, 6.83% yield
  • Guggenheim Taxable Municipal Managed Duration Trust (GBAB), $22.84, 6.61% yield
  • Nuveen Build America Bond Fund of Beneficial Interest (NBB), $21.07, 5.87% yield
  • Nuveen Build America Bond Opportunity Fund (NBD), $21.72, 5.28% yield

With the higher yields, these funds became favorite holdings in many individual investors’ IRAs (or other tax-sheltered accounts), as they could benefit from the higher yield and defer taxes while benefiting from the safety of municipal issuers.

Closed-End Fund Metrics: NAV Discount, Fees, and Leverage

As many investors in closed-end funds know, discount to NAV, management fees, and leverage are key metrics to watch and are reported on many websites, including CEFConnect and Morningstar.

A discount to NAV provides the investor a margin of safety, as it is the amount that the market price of the closed-end mutual fund is trading below the NAV of the underlying assets of the fund (note: open-ended mutual funds do not have this feature).

The second metric is management fees, where some closed-end funds have relatively high management fees which will act as a drag on investment returns.

The third common metric is leverage, where closed-end funds increase their distributions by borrowing money short-term to increase assets under management.

The table below summarizes these metrics for these funds:

Ticker

Yield

NAV Discount

Mgmt Fee*

Leverage

BBN

6.83%

-0.13%

0.86%

36%

GBAB

6.61%

-1.34%

1.00%

23%

NBB

5.87%

-3.53%

0.90%

28%

NBD

5.28%

-4.09%

0.95%

29%

* before interest charges

Source: CEFConnect

Currently, the NAV discounts are low compared to market history. The typical NAV discount for these funds is about 5%, with 10% NAV discounts occurring during times of bond market weakness.

The management fees (before interest) are about what you will see for most closed-end bond funds.

Finally, the leverage, at about one-third, is very similar across these funds. While having one-third of your NAV leveraged may seem risky, these funds can access short-term wholesale lending markets with cost of borrowing between 1.25 to 1.75%. This is significantly below margin interest rates that individual investors can access (at least 5%), as well as very much lower than the 6% to 7% coupons on these bonds, so the leverage does augment income distributions.

Thus, if we stick to the commonly reported metrics, these funds look pretty good - high yields, average management cost, and income-enhancing leverage - with only the low NAV discount providing a warning signal.

Difficult to find metrics: Duration, Yield to Maturity, Average Bond Price

More difficult to find are the metrics that will directly impact the valuation risk of these bond funds. Valuation is affected by Duration (or the amount of time it takes to receive your investment back in undiscounted dollars), Yield to Maturity (“YTM”), or the equivalent yield of the bond if held until its maturity, and average bond price, which indicates whether the bond is trading at a premium to par, and thus will trend down in price over time, or vice versa.

The table below summarizes these metrics:

Ticker

Distribution Yield

1-year low discount

Duration (yrs)

Yield to Maturity

Avg Bond Price

BBN

6.83%

-9.90%

11.0

5.22%

119

GBAB

6.61%

-11.72%

9.7

5.03%

115

NBB

5.87%

-6.93%

10.3

5.10%

120

NBD

5.28%

-8.78%

9.7

4.78%

122

Source: Author’s calculations based on individual security fact sheets and quarterly reports

Duration

First, let’s look at duration, which is the time it takes to recover half of your cash flows from a bond. Duration can be used to estimate how much price sensitivity your bonds have to changes in interest rates. The rule of thumb is each basis point (“bp”, or 1/100 of a percentage point) will change the bond price by 0.01 multiplied by the duration, with falling rates leading to a price increase and increasing rates leading a bond price decrease.

For example, BBN has a duration of 11 years. A 50bp increase in rates (or 0.5 percentage points) would lead to a price decrease of 5.5% (=50bp X 0.01 X 11). Generally, a longer duration is riskier, as interest rates can be more volatile the farther out they are. However, among these BAB funds, the dispersion of duration is from 9.7 to 11 years, which means that all of them are sensitive to interest rate changes.

Yield to Maturity and Average Bond Price

When market interest rates fall after a bond’s issuance, bonds will trade at a premium to par because secondary market investors will be willing to pay a higher price to receive the historically higher coupon. The yield to maturity is the equivalent yield of the bond if it were held until maturity, which will be lower than the coupon on these bonds, as market rates have fallen since they were issued.

Because these funds are invested in BABs that were all issued in the 2009-2010 time frame, the bonds in these funds have higher coupons than current market conditions and thus trade as premium bonds, or with a price higher than $100. Therefore, all of the funds have YTM lower than the current income distribution yield. While most of their fund’s bond holdings will not mature for 20 or 30 years, the bond premium will degrade over time and show up as a downward trend in NAV, holding all else equal.

Unfortunately, for most investors, it can be difficult to acquire this information.

The duration of these funds is usually buried on the second page of the mutual fund fact sheet, and the yield to maturity is usually not even reported (in order to get the YTM, I had to calculate it from average bond yield and bond maturity).

For long-term bond funds such as these, the risk to principal due to interest rate changes and the built-in decline of principal for premium bonds is at least as important as the well-reported NAV, management fee, and leverage.

Summary and Investment Thesis

Mutual funds specializing in taxable municipal bonds, or Build America Bonds, have been marketed to individual investors for their high yield, high quality credit, and taxation fit for IRAs. Since 2010, these funds have performed wonderfully for investors, as they have returned high income and have experienced a general upward trend in price.

However, the recent price increases have been due to narrowing of the NAV discount, not an improvement in the bond market.

While I do not have any reason to believe that a broad-based BAB bond price decline is imminent, a sudden increase in interest rates can cause a large drop in price due to the long duration (about 10 years) and the likely expansion of the NAV discount.

For example, a 50bp increase in rates would lead to a 5% drop in NAV, and a potential reversion to selling at a 10% NAV discount would mean an additional drop of 6-9%. Therefore, it is possible under a moderate market stress scenario for these bonds to lose 11% to 14% of their value ($2 to $3 per share) pretty quickly.

If this were to happen, holding to maturity would not achieve a recovery in value, because these funds are comprised of premium bonds that will steadily lose about 0.5% to 1.0% a year in value a year so that they reach par value at maturity.

Because I was holding some of these mutual funds (BBN, GBAB, NBB) in my IRA, there was no tax consequence of selling this position. As a result, I sold about 75% of my Build America Bond position last week and will look to sell more into further market strength.

Disclosure: I am/we are long GBAB, NBB.

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.

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