MNP - Quality Sold Off

| About: Western Asset (MNP)

Summary

MNP is a closed-end fund sponsored by Legg Mason, seeking a high level of current income derived from federally tax free municipal bonds.

The fund currently yields a 4.89% distribution and is trading at a discount of 6.97% to its Net Asset Value. (as of 10/10/2017).

In-depth discussion on the fund.

Note: Income Idea subscribers received a more detailed analysis along with in-depth thoughts beyond the numbers and implementation ideas on October 9th, 2017.

Munis, Munis, Munis.... tired of hearing about them yet?

You shouldn't be. =)

On a tax equivalent basis, municipal bonds are perhaps one of the most attractive asset classes in the fixed income world today. Yes, spreads have come down from the record highs a few years ago but there are plenty of opportunities around.

This week we are looking at subscriber requests. Yesterday we discussed the Putnam Municipal Opportunities Trust (PMO) and we found a solid fund, but one that was not particularly attractive for a new investment today.

Today we are looking at the Legg Mason Western Asset Municipal Partners Fund (MNP) and I believe it may be a diamond in the rough. Let's take a look.

Fund Basics

  • Sponsor: Legg Mason (LM)
  • Managers: Western Asset, Robert E. Amodeo (July 1, 2011), David T. Fare (July 1, 2011), Kenneth Leech (March 31, 2014)
  • AUM: $244 million in investment exposure, $160 million common assets
  • Historical Style: Investment Grade Municipal Bonds
  • Investment Objectives: The Fund seeks high current income exempt from Federal income tax and capital preservation through investment in investment grade tax-exempt municipal bonds
  • Number of Holdings: 179
  • Current Yield: 4.89% based on market price, monthly distributions
  • Inception Date: 1/29/1993
  • Fees: 1.41% Net Expense Ratio
  • Discount to NAV: 6.97%
  • AMT Exposure: 9.68% as of 6/30/2017

Sources: CEF Connect, Legg Mason Website, and YCharts.

The Sales Pitch

While I have not personally owned Legg Mason funds in the past, I will say, the website for the CEFs is quite impressive and almost any information which you may want is readily accessible.

The fund's sales pitch like other munis is all about federally tax free income. Legg Mason goes a step further with the graphic on its website.

Source: Legg Mason MNP Website

The Alpha/Fund Strategy

One of the two areas where I feel a bit short on information is the fund's strategy. The closest I can find comes from the fund's semi-annual report.

The Fund’s primary investment objective is to seek a high level of current income which is exempt from regular federal income taxes,*consistent with the preservation of capital. As a secondary investment objective, the Fund intends to enhance portfolio value by purchasing tax-exempt securities that, in the opinion of the investment manager, may appreciate in value relative to other similar obligations in the marketplace. Under normal market conditions, the Fund invests substantially all of its assets in a diversified portfolio of tax-exempt securities that are rated investment grade at the time of purchase by at least one rating agency and that the investment manager believes do not involve undue risk to income or principal.

Source: MNP Semi-Annual Report

The Portfolio

The fund is fully invested with 100% allocated to municipal bond exposure. Interestingly, the fund owned about 3% exposure to short-term variable rate demand notes.

Source: Legg Mason MNP Website

The top 10 holdings of the fund represent right about 20.98% of the fund with NJ Transportation-backed bonds making up the largest position at 2.55%.

Source: Legg Mason MNP Holdings Data

I give lots of credit to LM for providing full holdings data to be available as an excel download.

Like our Putnam fund yesterday, I am disappointed to not have an easy to find geographical breakdown of the investments. The only place I could locate it was in the semi-annual report and even that was just the core info.

Below is that data, compiled by self.

State Percentage of Portfolio Percentage of Net
New York 24.5% 16.2%
California 20.7% 13.7%
Texas 14.1% 9.3%
New Jersey 12.1% 8.0%
Illinois 9.4% 6.2%
Pennsylvania 9.0% 6.0%
Florida 8.4% 5.6%

Source: Legg Mason MNP Semi-Annual Report

Unlike many of the funds out there, New York is the top state here with 16.2% of the portfolio.

California, Texas, New Jersey and Illinois round out the top 5 with 13.7%, 9.3%, 8% and 6.2%, respectively.

Since everyone wants to know, let's take a look at Illinois exposure and in particular the one that worries most, the Chicago GO credit.

Source: Legg Mason MNP Semi-Annual Report

The fund is currently invested in four Chicago GO bonds with a total of $2.51 million par value and another $1 million par value Chicago Water Reclamation GO. Together it is $3.51 million in exposure, or 1.44% of investment exposure or 2.2% of common assets.

The rest of the Chicago exposure is revenue or utility-backed as we have seen with other funds. I have few issues with that credit at this time.

Illinois state GO obligations represent $1.7 million in par value.

Source: Legg Mason MNP Semi-Annual Report

This would be .7% of fund's investment exposure or 1% of common assets.

This GO exposure is minimal in the grand scheme of things.

Furthermore, there was no Puerto Rico exposure as far as I can find.

Looking over the sector breakdown shows the fund's tilt towards transportation-backed bonds making up 21% of the fund.

Source: Legg Mason Website

If we look at the maturity breakdown of the bonds we find the fund is positioned towards the intermediate to long end of the curve.

Only 20.16% of the fund's bonds mature in the next 10 years, and only 5.89% matures in the next five years.

This plays out two ways. First, if the long end of the curve continues to come down, the fund will benefit. If the entire interest rate curve moves up, the fund would get hurt a bit more.

Source: YCharts

The other aspect to consider is the issuer's ability to call bonds if it can refinance the bonds at a lower interest rate.

As per Legg Mason, about 35% of the fund is callable in the next five years.

Source: Legg Mason Website

True to form, the fund is definitely "investment grade" with 80.62% rated A or better and 95.95% rated BBB or better.

Source: Legg Mason Website

To put this into perspective, the last fund we looked at, PMO, was only 68% rated A or better and 85.43% BBB or better.

This is even higher than the Nuveen AMT-Free Quality Muni Income Fund (NEA) which is 69.6% A or better and 89.51% BBB or better.

The downside of this quality is the slightly lower distribution rate.

Putting it all together we can look at the fund statistics. Thanks to Legg Mason the information is right there on the website, easily obtainable for investors and analysts alike.

Source: Legg Mason Website

The fund has an average effective maturity of 9.4 years. This is about in line with what we find in most muni CEFs.

The average effective duration for the fund or how we measure risk is 9.84 years.

What this means is that for every 1% rise in interest rates, the fund's NAV is expected to decline by 9.84%. Please note, duration is a measure of risk, not maturity.

I am fairly certain this 9.84-year duration is already leverage-adjusted as in the semi-annual report the fund discusses its total effective duration of 6.64 years. That number leverage-adjusted gets us about 9.84.

What is quite interesting is that because of the quality tilt, even though this fund has a longer average maturity, it has a smaller duration; i.e., it is less risky to interest rates than even a lot of the so-called "short duration" type funds.

Overall, this is one of the highest quality municipal CEFs and open-end funds that I recall going over.

Leverage

This fund is levered through the use remarketed preferred stock, both traditional "Auction Rate Securities" and the newer "Variable Rate Demand Preferred Stock."

As of the last update, the fund had a total of $85,000,000 in preferred shares through two series.

Source: Legg Mason MNP Financial Status Update

Currently, $18.5 million of leverage comes through the remaining Auction Rate Securities which were issued at the fund's launch on April 2, 1993.

These "legacy" ARS (Auction Rate Securities) were at the center of the 2008 Financial Crisis and as we have discussed with our last fund, PMO.

The interest rate on these securities reset every seven days in an auction style environment throughout the various wirehouse brokerages, letting clients buy and sell these securities.

These securities, even though they were 40 or 50-year bonds, were able to be traded during those market environments. When the banks seized supporting the auctions these securities froze up and were trading at the "default rate."

In 2015, the fund made a tender offer and redeemed $66.5 million of these ARS and issued new Variable Rate Demand Preferred Stock.

VRDS is essentially an ARS although it has more protections in place for every party involved and in case of a "failed auction," if the situation did not resolve itself the fund would redeem those preferred shares.

As of May 31st, 2017, the fund paid a dividend rate of 1.331% on the legacy ARS and a much smaller .861% on the new VRDPS.

By having most of the leverage at much lower rates in the new VRDPS, the fund is maintaining lower expenses and is in a better position to sustain its distribution.

The Numbers

The fund is currently distributing a market price distribution yield of 4.89% and is trading at a discount of 6.97% to its NAV, or net asset value.

Source: CEF Connect

Like many CEFs and muni funds, it was hit during Q4 2016. The NAV and price per share did recover this year; however, we can clearly see the discount opening up starting in August. Thus why the fund has caught our interests.

This latest expansion of the discount to NAV is likely attributed to the recent distribution cut.

Looking back over the fund's lifetime, we can see the fund has operated for the most part at a discount, although it did trade at a premium for a good period of 2012 and 2013 along with a few months in 2016.
Source: CEF Connect

Interestingly the other Legg Mason/Western Asset closed-end funds are currently at a premium or a lower discount to NAV.

Looking next at the performance year to date, the fund has achieved a total return of 7.58%. The price per share increased 3.49% while the NAV increased 3.32%. We can clearly see the price per share declining in September even though the NAV remained flat.

Chart MNP data by YChartsOver the last year the fund has brought investors a 1.53% on a total return basis. The NAV was down 3.62% so the net income was there if you look at NAV +distributions. The price per share however was down more than 6.58% during the same period signifying the discount to NAV opening up more than 3%.

This is the opportunity that the fund brings investors today.

Chart MNP data by YCharts

To put the fund's performance into perspective, let's compare it to a number of peers and benchmarks.

The fund compares itself against the Bloomberg Barclays Municipal Bond Index, so we will once again use the SPDR Nuveen Bloomberg Barclays Municipal Bond ETF (TFI) to replicate the benchmark.

Let's also compare the fund against the largest muni CEF, the Nuveen AMT-Free Quality Muni Income Fund (NEA), one of my favorite small muni CEFs, the Delaware Investments National Municipal Income Fund (VFL) and the Nuveen Select Tax Free Income Portfolio 2 (NXQ). We will also look at it against the fund we last discussed, the Putnam Municipal Opportunities Fund.

Let's get started with YTD numbers.

Quite clearly, NMP comes in the middle of the pack on a total return basis together with the larger Nuveen AMT-Free Quality Muni Fund.

Chart MNP Total Return Price data by YChartsOn an NAV basis, the fund also comes in the middle of the pack. Of note, while NEA was in the middle on a total return basis, it has had the strongest NAV gains this year. I suppose it also had its discount to NAV open up.Chart MNP Net Asset Value data by YCharts

Over the last year, MNP does come in the bottom of the pack. This is strictly due to being focused on high quality. This year the strongest performing credits in the muni space were lower-quality credits, BBB and lower.

Chart MNP Total Return Price data by YChartsOn a 3-year basis the fund proves to be a solid contender achieving a 22.40% total return, coming in behind the Putnam fund. Interestingly until this year, it was the best performer; however, it was hampered with the discount to NAV opening up over the last year. Chart MNP Total Return Price data by YChartsThe 5-year time-frame shows Quality Vs. Lower-Quality as the Putnam and Delaware funds were top performers. The two Nuveen funds and our Legg Mason fund were in the second tier. All closed-end funds did outperform the ETF once again.Chart MNP Total Return Price data by YChartsOver 10 years the fund looks great and has led the way for most of it, except the last few months. Chart MNP Total Return Price data by YChartsWhat is interesting to me is that PMO and MNP are quite different funds, both in terms of positioning on the yield curve and the credit quality. Over 10 years, however, both have ended up in the same place.
Of course, let's keep in mind that this past performance is not there to give any signs of what may happen in the future, but merely to let us know how management has performed over various market cycles.

Bottom Line

The distribution was cut and investors headed for the door. That quick exit now presents an opportunity.

As we saw looking at the underlying NAV we see a solid fund with a terrific long-term track record.

On the pricing side, the fund's current discount of 6.97% is cheaper than the average over the last year. This discount has opened up quite a bit just over the last month as a reaction to that cut.

Source: CEF Connect

Looking at the current discount also shows the fund to be cheaper than many short- and longer-term averages.

Source: CEF Connect

As with a few other funds which we have looked at, the fund does have an open share repurchase plan with the ability to repurchase up to 10% of the fund's shares outstanding whenever shares are trading at a discount.

8. Stock repurchase program

On November 16, 2015, the Fund announced that the Fund’s Board of Directors (the “Board”) had authorized the Fund to repurchase in the open market up to approximately 10% of the Fund’s outstanding common stock when the Fund’s shares are trading at a discount to net asset value. The Board has directed management of the Fund to repurchase shares of common stock at such times and in such amounts as management reasonably believes may enhance stockholder value. The Fund is under no obligation to purchase shares at any specific discount levels or in any specific amounts. During the six months ended May 31, 2017, the Fund did not repurchase any shares.

Source: Legg Mason MNP Semi-Annual Report

Bottom line, here you have a very high quality portfolio of municipal bonds which are trading at an above market discount due to a recent distribution cut which was designed to maintain the health of the distribution. The fund is seriously worth consideration.

For more information on the fund, please visit the fund's website at Legg Mason - MNP Website.

For Income Idea readers I also discuss in-depth the quality of the distribution. I am also offering a trial subscription for a limited time. Sign up to get the complete analysis and give the service a try.

I hope you enjoyed this article and it was helpful in your due diligence. I also hope you now have a good understanding of the type of research we do beyond what you see in the regular articles.

I believe in active management that works, and I am here to help you find those opportunities. Please follow me here on Seeking Alpha as we look for those opportunities and sort out the good managers from the mediocre. Simply click the "Follow" button next to my name at the top of the article or on my profile page.

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.

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