Over the past few months, most of you have noticed our increased activity in closed-end funds as the inflow of volatility finally shook them up and created various arbitrage, and directional, opportunities for active traders like us.
Now that these products have grabbed our attention, we are continuously monitoring most funds by sector and will reinstate our Weekly Review, publishing a recap of the groups of interest.
No doubt the most interesting event which all of the market participants expected was the meeting of the Federal Reserve and their decision about the interest rates. So, on Wednesday the Central Bank of the United States held its policy rate in a range between 2.25 percent and 2.5 percent and pledged that future moves will be done patiently. The statements also included the fact that the economic conditions will be one of the determining factors for future decisions. All of the above information is important for the municipal bond closed-end funds and for the rest of the assets which have relatively high duration. However, the outcome of the event may be can be considered as positive for the Munis.
Source: Barchart.com - iShares National AMT-Free Muni Bond ETF
Over the past week, the iShares National AMT-Free Muni Bond ETF (MUB) continued its positive performance. The price of the main index reported a gain of $0.10 and finished the week at $109.08 per share. Additionally, it is important to mention the regular monthly dividend which was distributed. On Friday, the benchmark distributed $0.234 per share. Еven after the deduction of the dividend the index remained in green territory for the week.
As you know, we follow the performance of the U.S. Treasury bonds - considering them a risk-free product - with maturities greater than 20 years: the iShares 20+ Year Treasury Bond ETF (TLT). The reason for that is the strong correlation between these major indices, and the chart below proves it. Additionally, a statistical comparison is provided by our database software:
Source: Barchart.com - iShares 20+ Year Treasury Bond ETF
Source: Author's software
Comparison Of The Yields And Municipal/Treasury Spread Ratio
Investing in municipal bonds is popular because they have the potential to offer higher yields than similar taxable bonds. If an investor wants to know whether muni bonds are cheap in comparison to taxable bonds or Treasuries, they could find out by comparing them. However, this method does have its limitations, and the investor should perform a more thorough analysis before making a decision:
Source: Bloomberg.com, Municipal and Treasury Yields
Source: Bloomberg.com, Municipal and Treasury Yields
The Municipal/Treasury spread ratio, or M/T ratio as it is more commonly known, is a comparison of the current yield of municipal bonds to U.S. Treasuries. It aims to ascertain whether or not municipal bonds are an attractive buy in comparison. Essentially, an M/T ratio north of 1 means that investors receive the tax benefit of muni bonds for free, making them even more attractive for high net worth investors with higher tax rate considerations.
Source: Bloomberg.com, Municipal and Treasury Yields
The narrowing spread and 3-month LIBOR are important for the leveraged municipal funds, and they can be highly affected by them. The 3-month LIBOR rate is a commonly used funding benchmark for the municipal bond CEFs.
Source: YCharts.com, 10-2 Year Treasury Yield Spread and 3-Month LIBOR based on US Dollar
Source: Yahoo News, Municipal Bond Closed-End Funds News
Many funds from the sector announced their regular dividends. Among these were the Munis sponsored by:
- Massachusetts Financial Services
- Eaton Vance
1. Biggest price decrease
2. Biggest price increase
Review Of Municipal Bond CEFs
1. Lowest Z-Score
When I am sorting the table by the lowest one-year Z-score, my aim is to find the most statistically undervalued CEFs from the sector. The Z-score is an appropriate indicator to see how many times the discount/premium deviates from its mean for a specific period.
Over the past several months, the funds increased significantly their prices and their Z-scores increased their values, as well. Currently, we have only three funds which have Z-score below -1.00 point. Also, you will notice that all the participants in the sample are state-specific Munis. In general, I could say that it's getting very difficult to find a statistical edge to support our desire to review some of the funds as potential "Long" candidate.
Based on the statistical approach, BlackRock MuniYield Arizona Fund (MZA) is one of the most undervalued funds from the sector. Almost all of the assets from the portfolio of MZA are from issuers located in Arizona. "Education" and "Utility" sector have the biggest weight in the portfolio and the main part of the investments is labeled as "AA" and "A" ratings.
In December the dividend was decreased from $0.0520 to $0.0470 per share. This is one of the main reasons why the price fell and the fund is currently trading at 7.46% discount. The current yield is 4.37% and the yield on net asset value is 4.05%.
From the national Munis BlackRock Municipal Income Investment QualityTrust (BAF) is the one with the lowest Z-score. It is not part of the table because its statistical parameter is -0.10 point. I think it is worth to review it as a potential "Buy" candidate. Once again, we can not talk about a statistical edge but the discount of the fund is 9.78% and its current yield is 5.29%. The graph below compared the discount of BAF to its peers and gives a signal that BAF may be relatively undervalued at the moment.
2. Highest Z-Score
On the other hand, are the closed-end funds sorted by their highest Z-score. From a statistical point of view, they should be reviewed as potential "Sell" candidates. When I prepare my research for potential "Shorts" I want to see them traded at Z-score of at least 1.50 points and their price to be above or pretty close to their net asset value.
Last time the situation was almost the same and I suggested a pair trade which could be formed. The previous week, BlackRock Municipal Income Trust II (BLE) was traded at Z-score of 2.20 points. I recommended the idea to enter into a short position, but to hedge it with long positions in BlackRock Municipal Income Investment QualityTrust (BAF) and BlackRock MuniYield Fund (MYD). So, what happened on a weekly basis. The price of our short position fell by 0.71% and the prices of our long positions reported a total gain of 0.22%. In other words, the total profit of this pair trade is 0.93% on a weekly basis. Not so bad at all. Additionally, from my perspective, there is still a potential in this trade because their net asset values are strongly correlated but the price of BLE is still deviating.
This week, the situation with our chart leader BlackRock Long-Term Municipal Advantage Trust (BTA) is very identical and you can trade it with long positions in MYD and BBK. Currently, BTA has a Z-score of 2.80 points and discount of 3.80%. The yield of the fund is 5.21%. On the other hand, the Z-score of BBK is 1.00 point and its discount is 8.83%. On top of that BBK has a slightly higher current yield of 5.39%.
The average one-year Z-score in the sector is 0.93 points. Last time, the average Z-score of the municipal sector was 0.92 points. Currently, the average value of the statistical indicator remains positive and indicates for a time to close some of our long positions.
3. Biggest Discount
Neuberger Berman New York Intermediate Municipal Fund (NBO) is the fund with the biggest discount. It is interesting to notice that the spread between its discount and the discount of the rest of the New York Munis is relatively widened. A quick check of the investments will show us that "Higher Education" takes 24.50% of the portfolio. The fund has relatively low Option-Adjusted Duration of 8.7 years and 85% of its asset are rated with "Investment Grade" ratings. If you want to invest in New York, then NBO definitely deserves your attention.
Source: Fund Sponsor Website
4. Highest Premium
Probably, you noticed the dominance of the PIMCO funds. The market participants constantly pay a premium for them. If we do not have a strong logic behind our "Short" position, it can lead to unfavorable results.
The average discount/premium of the sector is -7.58%. Last time, the average spread between the prices and net asset values of the funds was again -7.58%. Slowly and gradually the funds manage to narrow the spread between their prices and net asset value.
5. Highest 5-year Annualized Return On NAV
The above sample shows the funds with the highest return on net asset value for the past five years. The average return for the sector is 5.50%. Several funds from the above observation caught my attention:
- Nuveen Municipal High Income Opportunity Fund (NMZ) has the lowest Z-score from the sample. Its yield of 5.47% is relatively high and is competitive even to the PIMCO funds. Even with such a high yield on price and yield on net asset value the fund has an earning coverage ratio of 106.19%.
- PIMCO California Municipal Income Fund II (PCK) is traded at its net asset value. It is a very rare occasion to see PIMCO fund traded at a discount or its net asset value. I consider this closed-end fund as a potential "Long" candidate especially if we take into consideration the premium of its brother PIMCO California Municipal Income Fund (PCQ).
6. Highest Distribution Rate:
The table shows the funds with the highest distribution rate on price. The average yield on price is 4.72%, and the average yield on net asset value is 4.38%.
Below on the chart, I plotted the yields of funds from the sector with a discount of more than 8.00% and negative Z-score.
7. Lowest Effective Leverage %
From a leverage perspective, we have seven closed-end funds whose effective leverage is equal to zero. The average effective leverage of the sector is 36.4%. Logically, most of the funds with lower effective leverage have lower distribution rates compared to the rest of the closed-end funds.
Below you can find the chart of the funds with the lowest effective leverage and their yields on price. If you are not a big fan of the high leverage, this chart will be very helpful.
The price of the iShares National Muni Bond ETF is still suffering from rising Treasury yields and future expectations. Definitely, the change of the interest rates will play a role, and we should anticipate a reflection on the Muni sector as well. Compared to the previous year, the discounts of the closed-end funds holding such products have significantly widened. While I find this to be fundamentally justified, I always expect some buying impulse to give us at least a mean-reversion trade in these products.
Note: This article was originally published on February 3, 2019, and some figures and charts may not be entirely up to date.
Trade With Beta
At Trade With Beta, we also pay close attention to closed-end funds and are always keeping an eye on them for directional and arbitrage opportunities created by market price deviations. As you can guess, timing is crucial in these kinds of trades; therefore, you are welcome to join us for early access and the discussions accompanying these kinds of trades
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PCK over 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.