Weekly Review: Municipal Bond CEFs - It Is Getting Difficult To Find Long Opportunities Based On The Z-Score

by: Arbitrage Trader

The main benchmark continues its upward trend after a new positive week.

We continue to follow the most important yields and municipal/Treasury spread ratio.

Most of the funds from the sector are traded at positive Z-scores, and we do not see a statistical edge to include some of them to our portfolio.


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.

Currently, we are cautious when we choose our long positions as most of the closed-end funds which hold municipal bonds have lost their statistical edge and are traded at positive Z-scores. However, there are several interesting pair trade opportunities which can be traded. For the conservative market participants with longer investment horizon, I still see interesting dividend opportunities which are traded at high discounts.

The Benchmark

Аfter a brief stumble, the price of the main benchmark reported new positive week. The iShares National Muni Bond ETF (MUB) remained in a green territory with a $0.20 increase on a weekly basis. The last two weeks were marked with very low trading volume and almost nothing interesting in the closed-end funds which invest in municipal bonds.

Source: Barchart.com - iShares National AMT-Free Muni Bond ETF

Over the past six months, we saw a very strong rally from the municipal bonds CEFs which was supported by the decreasing Treasury yields and statement that probably there will be no increase of the rates until the end of the year. Municipal bonds are financial instruments which have a longer duration compared to corporate and high-yield bonds. Therefore, the changes in the interest rates are crucial for their performance. As you know, bond prices and yields are inversely related.

Source: CNBC.com, US 10-Year yields

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.

Chart Data by YCharts

Source: YCharts.com, 10-2 Year Treasury Yield Spread and 3-Month LIBOR based on US Dollar

The News

Source: Yahoo News, Municipal Bond Closed-End Funds News

Over the past week, several funds from the sector announced their regular dividends:

  • Neuberger Berman Intermediate Municipal Fund (NBH) $0.0624 per share.
  • Neuberger Berman New York Intermediate Municipal Fund (NBO) $0.0393 per share.
  • Neuberger Berman California Intermediate Municipal Fund (NBW) $0.0448 per share.

Eaton Vance Municipal Bond Fund (EIM) commenced a tender offer:

A cash tender offer for up to 10% or 8,969,613 of its outstanding common shares at a price per share equal to 98% of the Fund's net asset value ("NAV") per share as of the close of regular trading on the New York Stock Exchange (NYSE) on the date the tender offer expires. The tender offer will expire at 5:00 P.M., Eastern Time on May 17, 2019 or on such later date to which the offer is extended. The pricing date will also be May 17, 2019, unless extended. If the number of shares tendered exceeds the maximum amount of the offer, the Fund will purchase shares from tendering shareholders on a pro-rata basis (disregarding fractional shares). Accordingly, there is no assurance that the Fund will purchase all of a shareholder's tendered common shares in connection with the offer.

Weekly Charts

1. Biggest price decrease

Source: CEFConnect.com

2. Biggest price increase

Source: CEFConnect.com

Review Of Municipal Bond CEFs

1. Lowest Z-Score

Source: CEFConnect.com

Sorting the funds by the lowest Z-score, we find out that only a few of them are statistically undervalued. The Z-score is an appropriate indicator to see how many times the discount/premium deviates from its mean for a specific period. In our case, we use it to find closed-end funds with a statistical edge for a "Long" position.

Currently, we cannot talk about some significant statistical edge in the municipal bond closed-end funds, but there are still several of them which can be reviewed as potential "Buy" candidates based on this statistical indicator. Combining the negative Z-score and the attractive discount, I see Nuveen Quality Municipal Income Fund (NAD) and BlackRock MuniHoldings Quality Fund II (MUE) as funds which deserve our attention. NAD is national Muni with 4.86% current yield and earning/coverage ratio of 104.30%. Based on the discount, it seems undervalued compared to its peers. The situation of MUE is very identical. It offers a 4.86% current yield, and its earning/coverage ratio is close to 100%.

Source: CEFdata.com

Source: CEFdata.com

PIMCO California Municipal Income Fund III (PZC) and PIMCO New York Municipal Income Fund II (PNI) remain among the funds with the lowest Z-scores. I remind you that the management team of PIMCO decided to decrease the dividend of several of their funds, and we observed a drop in their prices.

2. Highest Z-Score

Source: CEFConnect.com

Inversely, we use the highest Z-score as criteria to find potential "Sell" candidates among the funds. In addition to the statistical edge, I would like to find a fund traded at a premium in order to include it into my list. I am saying it because you will notice the attractive discounts which they traded at. So, I will definitely not take "naked" sell positions in them, but I can use them as a hedging reaction.

If you have a long position in BlackRock MuniAssets Fund (MUA), I see the current period as a good option to close it and to select another good buying opportunity from the sector. My personal opinion is that it is overpriced compared to its peers and its Z-score and premium are the confirming signals.

Source: CEFdata.com

Based on the statistical deviation between their prices, I see BlackRock MuniHoldings Fund II (MUH) and BlackRock MuniYield Quality Fund (MQY) as a very interesting pair trade. The price of the MUH has increased significantly over the past several months, and it almost reached the net asset value of the fund. These munis are very identical in their characteristics, and I do not see a fundamental reason behind the deviation in their prices. Our software confirms the strong correlation, and based on the statistical model, you can take a long position in MQY and short position in MUH. The desired outcome will be mean reversion between their prices.

Source: Author's software

Source: Author's software

The average one-year Z-score in the sector is 1.15 points. Last time, the average Z-score of the municipal sector was 1.36 points.

Source: CEFConnect.com

3. Biggest Discount

Source: CEFConnect.com

The above ranking highlights the current market situation and proves that you can still find interesting "Buy" opportunities in the sector. I think it is worth it to spend some time to review BlackRock MuniHoldings New Jersey Quality Fund (MUJ) and Eaton Vance California Municipal Bond Fund (EVM) as potential "Long" positions. Currently, they offer an attractive discount, and we see a relatively low Z-score.

Once again, Nuveen Michigan Quality Income Municipal Fund (NUM) is taking the first position after a 0.61% decrease in price and 0.07% decrease in the net asset value. The widened spread between the two values keeps the fund to the leading position of the ranking with a discount of more than 14.00%

Source: CEFdata.com

4. Highest Premium

Source: CEFConnect.com

Probably, you noticed the dominance of the PIMCO funds. The market participants constantly pay a premium for them due to their satisfying past results and faith in the quality of the management team.

Last week, I opened the topic about PIMCO California Municipal Income Fund (PCQ) and the potential dividend cut which may be expected. I saw many comments that, even with negative earning/coverage ratio, its UNII/Share balance will be enough to maintain the dividend in the next quarters. I think all of these predictions are difficult and the only possible choice which I have is to restrict myself from entering in a long position. It is traded at an extremely high premium, and my recommendation is to stay away from it.

The average discount/premium of the sector is -6.66%. Last time, the average spread between the prices and net asset values of the funds was -6.01%.

Source: CEFConnect.com

5. Highest 5-year Annualized Return On NAV

Source: CEFConnect.com

The average return on net asset value for the past five years for the sector is 5.14%. This table could be a good explanation of that desire and why PIMCO funds are differently treated. The funds from this sponsor proved that they can outperform their peers by return on net asset value over the past five years. All of these good performers, except Eaton Vance Municipal Income Trust (EVN), are traded at very high Z-scores and do not meet my requirements to review them.

6. Highest Distribution Rate:

Source: CEFConnect.com

If you are wondering which of the funds have the highest distribution rate on price, the above sample can help you to find the answer. Additionally, I have plotted here the distribution rate based on the net asset value. Most of the market participants find the second metric as the more important one.

The average yield on price is 4.52%, and the average yield on net asset value is 4.24%. Below on the chart, I plotted the yields of funds from the sector which are traded at negative or neutral Z-score.

Source: CEFConnect.com

7. Lowest Effective Leverage %

Source: CEFConnect.com

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. Seven funds from the sector have effective leverage equal to zero.

Below, you can find the chart of the funds with the lowest effective leverage and their yields on net asset value. If you are not a big fan of the high leverage, this chart will be very helpful.

Source: CEFConnect.com


Compared to the previous years, the discounts of the closed-end funds holding such products have significantly widened, but we remain cautious when we select our long positions due to the high Z-scores in the sector. However, there are several interesting pair trades which you can review.

Note: This article was originally published on April 21, 2019, and some figures and charts may not be entirely up to date.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in PCQ 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.