Weekly Review: Municipal Bond CEFs - Another Increase In The Average Z-Score Of The Sector

by: Arbitrage Trader

The benchmark distributed its monthly dividend of 0.2345, which was quite similar to the amount of $0.2348 from April.

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

The main event from the last week was the meeting of the central bank. Federal Reserve officials voted to hold its benchmark rate in a target between 2.25% and 2.50% on Wednesday, as a lack of inflation pressure outweighed an economy that otherwise is growing strongly. Some of the market participants even expected to see a decrease in the rates based on the statement of President Donald Trump that the lack of inflation may be a key reason for a rate cut.

Although we did not see a change of the rates, the municipal bonds and closed-end funds, which invest in them, reported another strong performance. Over the past week, the price of iShares National Muni Bond ETF (MUB) decreased by $0.03 and finished the week at $111.46 per share. It sounds impressive if we take into consideration that fact that the main index distributed its regular monthly dividend of $0.2345 per share.

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

Source: Dividend.com

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

Many funds from the sector announced their regular dividends. Among these were the Munis sponsored by:

  • Nuveen
  • Pioneer Investment Management
  • BlackRock
  • Massachusetts Financial Services
  • Eaton Vance
  • Invesco
  • Dreyfus

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

To figure out which of the funds from the sector are statistically undervalued, we use the Z-score indicator. It is an appropriate indicator to see how many times the discount/premium deviates from its mean for a specific period.

When I try to find interesting buying opportunities for you, I strive to combine the negative Z-score of the funds with attractive discount in order to review the fund as potential "Long" candidate. Currently, we do not have many options to combine these two metrics just because only ten funds from the sector have negative Z-score. Even with so small sample, I do see several funds which can catch your attention.

BlackRock MuniHoldings Quality Fund II (MUE) is a national municipal bond closed-end fund which is traded at -0.30 point Z-score and has 10.83% spread between its price and net asset value. As you see on the chart, compared to its peers, MUE is traded at a much higher discount. Although the dividend was decreased in December, the fund is still very competitive with its current yield of 4.82%. The main part of the investments is with ratings of "AA" and "A", which takes 65.46% of the total portfolio. It is very impressing to find out that 99.05% of the assets are rated as investment-grade quality.

Source: CEFdata.com

BlackRock MuniHoldings Quality Fund (MUS) is another buying opportunity which can be reviewed. Traded at -0.30 point Z-score and 11.07% discount, the fund offers 4.43% yield on its price. The earning/coverage ratio is an important characteristic which most of the investors observe and include in their analysis. It shows whether the earnings of the funds are enough to cover the dividend. In our case, we do have earnings of $0.0460 per share or earning/coverage ratio of 104.04%. At this moment, it seems high enough to protect the dividend from a decrease.

Source: CEFdata.com

2. Highest Z-Score

Source: CEFConnect.com

The main aim here is to show us which of the funds are statistically overpriced at the moment. Ideally, to find a reasonable "Sell" candidate, we would like to have a statistical edge accompanied by a premium. As you see, the first criterion is met, but it is difficult to find funds traded at premiums. Therefore, if you hold a long position in these funds which have Z-score higher than 2.00 points, I can recommend you to re-allocate your funds to similar investment which has a lower statistical parameter.

The average one-year Z-score in the sector is 1.19 points. Last time, the average Z-score of the municipal sector was 0.94 points.

Source: CEFConnect.com

3. Biggest Discount

Source: CEFConnect.com

Over the past week, only four funds reported a decrease in their net asset values. On the other hand, the trend in the prices is even stronger, and slowly but steadily, most of the Munis narrow the spread the price and the net asset value. Yes, it is still possible to buy many of the funds at a significant discount, and the table above represents the top ten biggest discounts in the sector.

Neuberger Berman California Intermediate Municipal Fund (NBW) is taking again the first position with its 13.50% discount. On a weekly basis, the price of the fund fell by 0.76%, while its net asset value remained almost flat with its 0.07% decrease. Personally, I am not very interested in state-specific Munis and prefer to hold funds with a well-diversified portfolio. However, if you decide to include NBW to your portfolio, you can achieve a 4.11% return of the current price and 3.56% yield on its net asset value.

The average discount/premium of the sector is -6.28%. Last time, the average spread between the prices and net asset values of the funds was -6.78%.

Source: CEFConnect.com

4. Highest Premium

Source: CEFConnect.com

Moving forward, we reach the section where is almost impossible to miss the topic about PIMCO funds. PIMCO California Municipal Income Fund (PCQ) keeps the leading position after the announced dividend. As you know, the earning/coverage ratio of the fund is below 100%, and some of the market participants expect to see dividend cut in the next months or quarters. I support this theory and recommended to leave this "sinking boat" as soon as possible. No doubt, an eventual dividend cut will have a negative reflection on the price.

If you have a long position in BlackRock MuniAssets Fund (MUA), I see the current period as favorable 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

5. Highest 5-year Annualized Return On NAV

Source: CEFConnect.com

The above sample shows the funds which outperformed their peers. The average return on net asset value for the past five years for the sector is 5.21%.

Аlthough PIMCO funds are one of the best performers, Eaton Vance Municipal Income Trust (EVN) achieved a higher return on its net asset value. This closed-end fund is still traded at 9.42% discount, and its Z-score is relatively low. If the historical performance of the fund is important for you, you will want to review EVN as a potential candidate for your portfolio.

6. Highest Distribution Rate:

Source: CEFConnect.com

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 4.45%, and the average yield on net asset value is 4.18%.

Very long time, Invesco Pennsylvania Value Municipal Income Trust (VPV) was the fund with the higher current yield in the sector. Several times, I warned you for the risk about a dividend cut. The earning/coverage ratio signaled for difficulties to cover the dividend unchanged. After all, there is justice, and the management team announced the dividend cut from $0.0580 to $0.0535 per share.

Source: CEFAnalyzer.com

Below on the chart, I plotted the yields of funds from the sector which are traded at negative 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 May 05, 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.