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.
Тhe stock market reported a negative week as the market participants closely monitor the U.S.-China trade talks and still expect to see the final outcome. This uncertainty for the equities was a main factor for some of the investors to change their focus to safer assets. One of the weekly winners were the municipal bonds and the closed-end funds which invest in them.
Over the past week, the price of the main benchmark iShares National Muni Bond ETF (MUB) increased its value by $0.43 and finished the Friday session at $111.89 per share. The positive impulse led to the new highest level for the current year and the new highest level since the November 2016 year. Definitely, it's been a long time since the main index was traded around these prices.
Source: Barchart.com - iShares National AMT-Free Muni Bond ETF
The performance of the sector continues to have a strong negative correlation with the movements of the U.S. Treasury yields. Currently, the 10-year Treasury yield remains close to its lowest levels for a one-year period, which left room for municipal bonds to increase their prices.
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.
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
Over the past week, several funds announced their dividends:
- DWS Strategic Municipal Income Trust (KSM), $0.0475 per share.
- DWS Municipal Income Trust (KTF), $0.0425 per share.
- Putnam Municipal Opportunities Trust (PMO), $0.0531 per share
- Putnam Managed Municipal Income Trust (PMM), $0.0320 per share
- Delaware Investments National Municipal Income Fund (VFL), $0.0500 per share
- Delaware Investments Minnesota Municipal Income Fund II (VMM), $0.0375 per share.
1. Biggest price decrease
2. Biggest price increase
Review Of Municipal Bond CEFs
1. Lowest Z-Score
My first criterion is a statistical one. I use the Z-score as a signal for undervalued or overpriced funds in the sector based on their deviations in the discount or the premium. A Z-score is a numerical measurement used in statistics of a value's relationship to the mean (average) of a group of values, measured in terms of standard deviations from the mean.
If we take into consideration the fact that this sector was very strong over the past six months, you will not be surprised to find that most of the closed-end funds have positive Z-score. Of course, if you believe in the future upside potential in the prices of the municipal bond funds, there are still several closed-end funds from the sector which can be bought at negative Z-score.
BlackRock Municipal Bond Trust (BBK) is one of the interesting options which can be reviewed as a potential "Long" candidates. Its Z-score of -0.30 point is accompanied by an attractive discount of 10.57%. Compared to the rest of the national municipal closed-end funds, BBK is undervalued from my perspective.
The current yield on net asset value is 4.04%, and the current yield on price is 4.52%. Also, it is important to mention that the fund manages to keep a positive earning/coverage ratio and UNII balance per share.
Аlthough it is not traded at discount, I see PIMCO New York Municipal Income Fund II (PNI) as a buying opportunity. PIMCO funds are highly appreciated by the market participants, and it is a very rare event to see some of them be traded close to its net asset value. One of the reasons behind this fact is their satisfying past results. Currently, PNI is traded at 0.54% premium and offers 4.27% current yield.
2. Highest Z-Score
Here, sorting the funds by the highest Z-score in order to find "Sell" candidates or at least to figure out where is time to close our long positions.
BlackRock MuniYield Quality Investment Fund (MFT) is taking the first position of the raking with its Z-score of 2.80 points. For the last month, MFT increased its price by 7.96%, while its net asset value reported a gain of 1.59%. Currently, the fund is traded at a slight premium, and I strongly recommend to close your long position here and to re-allocate your funds in some of its peers. The only reason which I see behind the strong increase in the price is the relatively high current yield, which is offered by MFT. The investors should be aware that the latest earning per share were not enough high to cover the dividend, which could be transformed into a dividend cut very soon.
The average one-year Z-score in the sector is 1.06 points. Last time, the average Z-score of the municipal sector was 1.19 points.
3. Biggest Discount
The sample provides us CEFs with attractive discounts of more than 12%, and I would suggest combining the spread between the price and net asset value with a relatively low Z-score. Very quick research will show us that most of them are state-specific. The national Munis are currently traded at a smaller discount, most probably due to their diversified portfolio.
The Nuveen Pennsylvania Investment Quality Municipal Fund (NQP) is one of the interesting funds which caught my eye. Maybe a little bit surprising, but the management team decided to increase the dividend of the fund from $0.0470 to $0.0505 per share from the month of March. Still based on the discount, the fund seems undervalued compared to its peers. The current yield of NQP is 4.51%, and 97.9% of its assets are from issuers located in Pennsylvania.
Source: Fund Sponsor Website
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. My simple recommendation here is to stay away from long positions in PIMCO California Municipal Income Fund (PCQ) and BlackRock MuniAssets Fund (MUA). I find them as overpriced due to their high Z-scores and premiums. Also, for PCQ, I do expect to see a dividend cut in the next several quarters.
The average discount/premium of the sector is -6.36%. Last time, the average spread between the prices and net asset values of the funds was -6.28%.
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 5.19%. From the above participants and their parameters, only PIMCO New York Municipal Income Fund II (PNI) and the Eaton Vance Municipal Income Trust (EVN) caught my eye with their relatively low Z-scores.
6. Highest Distribution Rate:
In this section, we see which are the funds with the highest current yields. The average yield on the price for the sector is 4.43%, and the average yield on net asset value is 4.16%.
Unfortunately, most of them are overpriced based on their Z-scores. Of course, each of us wants to achieve higher return, but you need to pay attention to the fundamental analysis and to avoid these ones which are threatened by dividend cuts. The case with Invesco Pennsylvania Value Municipal Income Trust (VPV) was a very good example. It has the highest yield in the sector, but the earning per share was not enough high to cover the dividend, and the management team decided to decrease it from $0.0580 to $0.0535 per share.
7. Lowest Effective Leverage %
The average effective leverage of the sector is 36.2%. 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 May 12, 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.