How To Spot CEF Value Traps: A Case Study With MAV

|
About: Pioneer Municipal High Income Advantage Trust (MAV)
by: ADS Analytics
Summary

MAV features a low discount relative to its history and consequently a low z-score which may signal that the fund is attractively valued.

However, we argue that this is not the case and that relying on z-score may generate false positives for investors looking for attractively valued funds.

We recommend investors instead use a combined metric of discount alongside "coverage yield," or yield that reflects the earning power of the fund.

Faced with possibly dozens of closed-end funds to analyze in any given sector, it is tempting to do something simple like sort the funds by discounts and z-scores in order to select the most attractively valued options.

In this article, we argue that this can go wide of the mark because discounts tend to adjust with distributions, so ignoring the recent distribution history can make low z-scores flash a false positive. This is true even if they are included as part of a broader metric.

Because discounts are effectively a price on a set of underlying cash flows (fund distributions), discounts need to be analyzed alongside these distributions. However, because current yield and past 12-month yield do not capture the true earning power of the fund, we argue that discounts need to be paired with 'coverage yield', sometimes called NII yield which reflects the fund's actual earning.

To illustrate this dynamic, we discuss the Pioneer Municipal High Income Advantage Trust Fund (MAV) and show that while the fund may appear attractive given its low z-score, it is actually much less attractive once we take into account the current earning power of the fund.

MAV - More Like Meh

If we sort national municipal closed-end funds along the 1y z-score metric, MAV clearly stands out as a winner. To understand why this is the case, we need to look at its trading history.

Source: ADS Analytics, TIINGO

Historically, at least until about 2018 or so, MAV has tended to yield substantially more than the rest of the sector.

Source: ADS Analytics, TIINGO

We suspect this is because MAV was overdistributing - we can tell this by comparing net NAV (NAV excluding distributions) of the fund and the sector. MAV net NAV trajectory was lower than the rest of the sector which does suggest that it was not covering its distribution and was shedding NAV via overly generous distributions.

Source: ADS Analytics, TIINGO

It will surprise few people who follow CEFs that MAV, due to its generous yield, also enjoyed a tighter discount than the rest of the sector, particularly during the period until 2015 before it began to cut its distribution.

Source: ADS Analytics, TIINGO

In about 2015 or so, MAV management decided to right-size its distribution and began to severely cut it - much more so than the rest of the sector.

Source: ADS Analytics, TIINGO

If we plot the two metrics on the same chart, it becomes clear what is going on. The MAV discount tended to move together with its distribution - as the fund increased the distribution, the discount tightened and as the fund cut its distribution, the discount widened.

Source: ADS Analytics, TIINGO

So what are we getting at?

Well, the low MAV z-score suggests that MAV is good value, however, because MAV has recently cut its distribution, it is effectively no longer the same fund that the z-score references.

In other words, of course, we would expect the MAV discount to widen - MAV is no longer offering a compelling yield. And because the discount is widening, the z-score will by definition be low.

The problem with z-score is symmetric - if a fund had increased its distribution rate (hopefully sustainably) then it would screen as overly expensive because its discount would most likely move tighter, all else equal.

In fact, the problem is really as much with the discount as with the z-score. In order to really gauge whether a fund is attractive, we cannot rely on discount or z-score alone.

At this point, I can hear some readers reply - "Of course I don't just rely on discount or z-score, I rely on current yield." The problem with this, however, is that fund distribution rates are fairly arbitrary and often do not reflect the actual earning power of the fund so can leave investors vulnerable to distribution cuts and subsequent price drops.

So, what are we to do?

Instead of binning discounts and using current yields, let's instead focus on the true earning power of the fund and move discounts into a secondary valuation role.

Coverage yield, or perhaps more commonly called NII yield, gets a lot closer to the true earning power of the fund while discounts act as a secondary additional "margin of safety" metric.

We think this combination of coverage yield and discount is powerful for two reasons:

  • For the same coverage yield, a lower discount means the underlying assets are likely to be lower risk (i.e. having a lower "par" yield).
  • A wider discount, all else equal, should provide an additional margin of safety for any surprise distribution cuts

So, our preferred valuation metric is that for a given level of coverage yield, we prefer a wider discount all else equal.

Let's see what this looks like for the muni sector.

Relative to MAV (marked with a red dot in the chart):

  • Funds that are more expensive on this metric have a lower coverage yield and/or a tighter discount for the same yield (marked in red).
  • Funds that are cheaper on this metric have a higher coverage yield and/or a wider discount for the same yield (marked in green).

Source: ADS Analytics, TIINGO

We zoom in on the "cheaper" funds in the table below, highlighting MAV for reference.

Source: ADS Analytics, TIINGO

The second thing we can do is to potentially identify funds across other CEF sectors giving us a false positive going forward by screening for funds that have had large distribution cuts and are trading at a low z-score. We list these funds in the chart below.

Source: ADS Analytics, TIINGO

Conclusion

There is no perfect simple valuation metric for CEFs. However, relying simply on discounts and z-scores often misses the mark. It is easy enough to screen a group of funds for discounts and z-scores. However, the trouble with primarily relying on these metrics is that they typically only tell us half the story. The stream of distributions that the closed-end fund provides is a moving target and so any analysis of discounts and z-score needs to take it into account. In particular, as part of their analysis, we think investors should consider "coverage yield" as the metric against which to compare discounts of a group of funds.

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.