Aggressive And Conservative CA Muni CEF Choices + Illustration Of Quantitative Screening Process

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Includes: AKP, BFZ, BJZ, CCA, CEV, EIA, EVM, MCA, MUC, MYC, NAC, NBW, NCA, NCB, NKX, NXC, PCK, PCQ, PHK, PZC, VCV
by: Stanford Chemist
Summary

What fund might one replace PCQ with?

Illustration of quantitative screening process.

Yield is not the first thing that I look at!

https://static.seekingalpha.com/uploads/2018/1/12/saupload_12936326_1.jpg

In yesterday's piece, Get Out Of This PIMCO CEF While You Can, we discussed how PIMCO California Municipal Income Fund (PCQ) should probably be avoided given its high premium of +20%, and a possible future distribution cut.

What are some alternative CA muni funds that one could replace PCQ with? The obvious swap would be to PIMCO California Municipal Income Fund II (PCK) or PIMCO California Municipal Income Fund III (PZC), the other two PIMCO CA muni CEFs. However, besides PIMCO funds, are there any other alternatives?

With many new members joining the Cambridge Income Laboratory in the past month, I thought now would be a good time to illustrate again the quantitative screening process I use to shortlist CEFs for further consideration. Note that I wrote "shortlist" only; for final decision for inclusion in a portfolio I always conduct further due diligence such as by inspecting relevant fund literature and understanding the fund's portfolio and strategy.

The table below shows the 20 CA muni CEFs in CEFConnect's database.

Name Ticker Share Price NAV Premium/Discount Distribution Rate
Alliance CA Municipal Income (AKP) 13.54 15.28 -11.39% 3.73%
BlackRock CA Municipal Income (BFZ) 13.83 15.2 -9.01% 4.77%
BlackRock CA Muni 2018 Term (BJZ) 14.72 14.85 -0.88% 0.20%
MFS California Municipal Fund (CCA) 11.49 12.54 -8.37% 4.39%
EV CA Municipal Income (CEV) 12.24 13.87 -11.75% 3.64%
EV CA Muni Bond II (EIA) 11.6 12.75 -9.02% 4.57%
EV CA Municipal Bond (EVM) 11.65 12.27 -5.05% 5.02%
BlackRock MuniYield CA Quality (MCA) 14.64 15.71 -6.81% 4.80%
BlackRock MuniHoldings CA Qty (MUC) 14.27 15.48 -7.82% 4.50%
BlackRock MuniYield CA (NYSE:MYC) 14.91 15.49 -3.74% 4.99%
Nuveen CA Quality Muni Inc (NAC) 14.36 15.63 -8.13% 4.89%
Neuberger Berman CA Inter Muni (NBW) 13.78 15.13 -8.92% 4.46%
Nuveen CA Muni Value (NCA) 10.27 10.44 -1.63% 3.51%
Nuveen CA Municipal Value 2 (NCB) 17.75 16.27 9.10% 3.65%
Nuveen CA AMTFree Qlty Muni In (NKX) 15.37 15.83 -2.91% 4.84%
Nuveen CA Select Tax-Free (NXC) 15.86 15.33 3.46% 3.52%
PIMCO CA Municipal Income II (PCK) 9.08 8.64 5.09% 4.63%
PIMCO CA Municipal Income (PCQ) 17.405 14.15 23.00% 5.31%
PIMCO CA Municipal Income III (PZC) 10.69 9.94 7.55% 5.05%
Invesco CA Value Muni (VCV) 12.63 13.37 -5.53% 5.08%

Premium/discount

One of the first factors that I look at is premium/discount. If a fund trades at significant (over 15-20%) premium, I often ignore it completely as the risks of capital loss resulting from premium contraction are too great. In general, the wider the discount the better, although one has to be careful to avoid "value traps" (perhaps "discount trap" is a more apt description). Some funds may trade at a persistent and wide discount for many years for good reason, which is where the z-score (see below) comes in handy.

We can see that PIMCO's CA muni funds (even PZC and PCK that recently cut their distributions) trade at elevated premiums compared to the rest of the CA municipal CEFs. Only Nuveen California Municipal Value Fund 2 (NCB) trades at a higher premium than PCK and PZC. In the following charts, the PIMCO funds are highlighted in orange, and I'll be making particular references to them in the analysis since they were the original stimuli for this piece.

(Source: Stanford Chemist, CEFConnect)*

(*I accidentally included NTC, a CT muni CEF in some of the charts, please ignore it where you see it)

Z-score

I next take a look at the fund z-scores. Simply put, the z-score is a measure of how far the current premium/discount of a CEF is from its historical average. The calculation of the z-score also takes into account the volatility of the premium/discount in question. Another way to put this is that the z-score is a measure of how many standard deviations the current premium/discount is from the historical average premium/discount.

A positive z-score indicates that a fund is trading above its historical premium/discount average, and hence indicates relative overvaluation. Conversely, a negative z-score indicates that a fund is trading below its historical premium/discount average, indicating relative undervaluation. For more explanation on z-scores, see this Fidelity article.

PCQ trades at the highest 1-year z-score of +1.7. All the more reason to sell it while you can! PCK trades at an extremely low z-score of -5.2 due to its recent distribution cut that collapsed its share price.

(Source: Stanford Chemist, CEFConnect)

Performance

I next look at historical performance. Here, I consider NAV returns and not price returns. This is because the price return can be influenced by changes in the premium/discount of the fund, which is not something that is really under the control of the fund management. Moreover, I consider NAV total return which includes (reinvested) distributions, as different CEFs may have paid out different amounts in yield. Moreover, as CEFs do generally pay out high distribution yields, it's not really meaningful to look at the return without dividends included - as detractors of CEFs love to do: E.g. "PIMCO High Income Fund (PHK) has lost half of its value since inception, it's a terrible investment!". While the first part of the statement is true, you'd be hard pressed to find someone who would turn down a +240% return (~13% annualized).

Chart

PHK data by YCharts

Back to the task at hand, I often look at 1-, 3- and 5-year NAV returns. For this exercise on CA muni CEFs, I'm only going to look at 5-year returns because nothing particularly earth-shattering has happened to the muni market over the past several years, so consistency in long-term performance is what I'm looking for.

When we check out the 5-year NAV total returns of the CA muni CEFs, the three PIMCO funds are clear winners, with PCK leading the pack at +6.7% annualized over the last 5 years.

(Source: Stanford Chemist, CEFConnect)

Leverage

Is this a clear case of PIMCO magic? Not so fast. The three PIMCO funds also use the highest leverage out of the peer group, which would definitely boost their performance compared to funds that use lower leverage or don't use leverage at all.

(Source: Stanford Chemist, CEFConnect)

Still, even after accounting for differences in leverage, the PIMCO funds are still in the upper echelon of the peer group. Maybe there is a bit of magic after all.

(Source: Stanford Chemist, CEFConnect. *Denotes adjusted for leverage)

Expense ratio

It's also very important to look at the expense ratio of the funds. Performance can go up or down, but fees are always a constant (drain). Obviously, the lower the yield the fees are better, all other things being equal. But sometimes, it's worth paying higher fees if the performance is justified.

I prefer to look at baseline expense ratio than total expense (which includes interest fees). This is because interest fees are used to maintain leverage, which ostensibly benefits the investor (compared with an investor accessing margin from their own broker, which is usually much more expensive). Moreover, interest expenses vary with the prevailing interest rates, making it difficult to compare fees if looking at data or articles from different dates.

In terms of baseline expense ratios, PIMCO's CA muni CEFs charge above average fees compared to the rest of the group.

(Source: Stanford Chemist, CEFConnect)

Distribution yield

Finally, PIMCO's PZC and PCQ offer the highest distribution yield (on price) of 5.05% and 5.31%, respectively, while PCK's 4.61% is somewhere in the middle of the pack.

(Source: Stanford Chemist, CEFConnect)

Notice that yield is one of the last criteria that I consider for selecting CEF investments, and normally doesn't have a huge impact on fund selection strategy. Why is this?

As I've written about many times before, when funds are being invested in the same universe, and with broadly similar leverage, we'd expect their portfolios to have similar yields (assuming similar credit/duration profiles, which may not always be the case). Therefore, a higher yield would be compensated for by a slower NAV growth, and vice versa, but total return should, in theory, be about the same.

In a similar vein, distribution stability is not a paramount factor that I consider. In fact, as the very example of the PIMCO CA muni CEFs shows, the observation that investors (irrationally?) bid up "stable" dividend payers simply sets the stage for massive disappointment and losses when a cut is announced. The flip side of this is that right after a distribution cut is often a great time to scoop up CEFs at a bargain price.

With CEFs, there are two wrinkles that may make the yield more relevant to consider. The first is that a high yield coupled with a high discount generates alpha. Secondly, one should be careful that the yield is not "too high" that it becomes destructive and erosive to NAV. These two aspects need to be considered on a case by case basis, and in light with the other screening criteria considered above.

Summary

Even though I know that not all members may be interested in CA muni funds (how many Californians do we have here anyway?), I hope this serves as a nice illustration of the quantitative metrics I consider when looking at CEFs to shortlist. If I had to pick a CA muni CEF to replace PCQ, these would fall into two categories.

Aggressive choices would be PIMCO's other two CEFs, PCK and PZC. These two funds use high leverage and have had strong historical performance. PCK trades with a premium of +5.09% and offers a yield of 4.61%, which is 133% covered. Meanwhile, PZC has a slightly higher premium of +7.44%, and yields 5.05% with 98% coverage.

Conservative choices would be Nuveen's Nuveen California Municipal Value Fund (NCA) and Nuveen California Select Tax-Free Income Portfolio (NXC). Both funds use 0% leverage (and thus are not hurt by rising short rates, which increases interest expenses), and charge extremely low baseline expense ratios of 0.36% and 0.57%, respectively. However, because of their lack of leverage, NCA and NXC offer lower yields of 3.51% and 3.57%, respectively. NCA's yield is 102% covered, while NXC's is 101% covered.

Despite being unleveraged, NCA and NXC still produced very decent 5-year NAV returns that fell somewhere in the middle of the pack, but once the other funds' leverage were accounted for, NCA and NXC rose to become the 3rd and 2nd best ranked funds on a leverage-adjusted basis! NCA currently trades with a discount of -1.72% (z-score: -1.2), while NXC sports a premium of +1.04% (z-score: +0.5).

Of course, as I wrote near the start of the article, these are simply the shortlisted CEFs that I find most attractive in the quantitative analysis. Further due diligence is suggested before adding these funds to your portfolio.

This article was originally published to members of the Cambridge Income Laboratory 1 month ago.

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.