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.
Usually, I am trying to summarize the performance of the sector in this paragraph. The sector is so strong, and for me, it is something like a common event to tell you that its benchmark iShares National Muni Bond ETF (MUB) reported a positive week. We saw another increase of $0.62 in the price of the main index and a new highest level for the year.
The market participants are focused on the next meeting of the Federal Reserve which will be next Wednesday. Most of the expectations are the central bank to hold the interest rates unchanged, but it will be interesting to see if there will be some surprises. Municipal bonds and closed-end funds which invest in them 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: Barchart.com - iShares National AMT-Free Muni Bond ETF
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
Several funds announced their regular dividends:
- AllianceBernstein National Municipal Income Fund (AFB) $0.0458 per share.
- Alliance California Municipal Income Fund (AKP) $0.0421 per share.
1. Biggest price decrease
2. Biggest price increase
Review Of Municipal Bond CEFs
1. Lowest Z-Score
Above, I have plotted potential "Buy" candidates based on their Z-score. The purpose of this indicator is to show us how many times the discount/premium deviates from its mean for a specific period.
It is interesting for me to see that we still have closed-end funds from the sector which are traded at negative Z-score. It is true that we cannot talk about a significant edge, but, in such strong uptrend, even a negative Z-score is a reason to review a fund as potential "Long" candidate. Also, I would like to highlight the fact that each of the 137 municipal bond closed-end funds reported an increase of its net asset value on a weekly basis. This is a fact which comes as a confirmation for the positive performance of the sector.
My attention was caught by BlackRock MuniYield Quality Fund (MQY). It is among the funds with the lowest Z-scores and I find its valuation as pretty attractive. Currently, you can include it to your portfolio at 11.11% discount of its net asset value. Another positive which I see here is the relatively high yield of 4.83% which is offered by the fund. Furthermore, you will be happy to find out that its earning/coverage ratio and UNII/share balance are positive.
2. Highest Z-Score
If we take into consideration the current market situation, we should not be surprised by the outcome of our observation. Many of the funds have positive Z-scores, but it is difficult to label them as "overpriced" because some of them are still traded at high discounts.
Yes, maybe the sector will continue its strong uptrend and very soon we may see many of the funds to be traded at premiums, but my recommendation will be to play this game in a smart way and to re-allocate your fund from some funds which pretend to be overpriced based on the Z-score to fund which are undervalued based on the same metric. To clarify what I said, I will give you a very good example:
BlackRock MuniHoldings Fund II (MUH) is traded at 2.40 Z-score and its price is only 1.44% below its net asset value. The current yield of the fund is 4.89%. The chart below indicates that the fund may be overpriced compared to its peers, so I will close my long position here and move to BlackRock MuniYield Quality Fund. The offered yield is very identical, but I will increase my chances for capital gain when I buy a fund which is traded at lower Z-score and higher discount.
From the above sample, I see BlackRock MuniHoldings Fund II, BlackRock MuniAssets Fund (MUA), Neuberger Berman Intermediate Municipal Fund (NBH), and BlackRock Municipal Income Trust (BFK) as funds where you can consider the closing of your long positions. Furthermore, if I need a hedging reaction to some of my long positions, these four Munis will be the first one which I am going to use.
The average one-year Z-score in the sector is 0.94 points. Last time, the average Z-score of the municipal sector was 1.15 points.
3. Biggest Discount
The average discount/premium of the sector is -6.74%. The funds plotted above are trading below their net asset value, which is a sign that we can find a bargain. Based on the market conditions, I find as interesting to review the BlackRock MuniYield Pennsylvania Quality Fund (MPA) and BlackRock New York Municipal Quality Trust (BSE). Yes, MPA has positive Z-score, but I still find its valuation attractive based on the discount.
4. Highest Premium
PIMCO funds continue to be the ones which are traded at the highest premium. The trust in the management team and the good past results are one of the main reasons why the market participants want to have them even at a price higher than the net asset value.
PIMCO California Municipal Income Fund II (PCK) was the best performer of the past week. Its price reported 3.98% increase which helped PCK to be closer to its brothers.
I have already notified our subscribers about the risks to hold a long position in PIMCO California Municipal Income Fund (PCQ). The earning/coverage ratio of the fund remains below 100% and the downtrend of the UNII/share balance is obvious. Sooner or later, this will reflect on the dividend and the price of the fund. A better option here is to re-allocate your fund to PIMCO California Municipal Income Fund III (PZC). These two funds are almost identical in every aspect, but PZC is traded at a much lower premium.
5. Highest 5-year Annualized Return On NAV
This table could be a good explanation of why the market participants pay a premium for PIMCO funds. The funds from this sponsor proved that they can outperform their peers by return on net asset value over the past five years.
If I exclude the Munis traded at a premium or very high Z-score, then Eaton Vance Municipal Income Trust (EVN) remains the only one possible choice to be reviewed as a potential "Long" candidate.
6. Highest Distribution Rate:
The table shows the funds with the highest distribution rate on price. Additionally, I have included here the distribution rate based on net asset value. Most of the market participants find the second metric to be more important. The average yield on price is 4.50%, and the average yield on net asset value is 4.21%.
My recommendation here is to check also the earning coverage ratio and the UNII/share balances of the funds which offer higher yields. I am saying it because if the earnings are not enough high to cover, the dividend is possible to see a decrease of the distribution which is going to affect the yield of the funds and it is very likely to see a decrease in its price.
Below on the chart, I plotted the yields of funds from the sector which are traded at negative Z-score.
7. Lowest Effective Leverage %
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.
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 28, 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 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.