Weekly Review: Municipal Bond CEFs - The Uncertain Market Environment Gave A Positive Impulse To The Sector

by: Arbitrage Trader

The investors changed their focus to safer assets due to the uncertainty around the trade deal and the volatility on the stock market.

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 benchmark of the municipal bonds iShares National Muni Bond ETF (MUB) reached new highest levels for the year after another positive performance. Over the past week, the main index increased its price by $0.54 and finished at $112.43 per share.

The recent volatility in the stock market and all of the events around the trade deal and its potential outcome continued to be a worrying factor for the market participants. As a result, we saw more demand for safer assets such as municipal bonds and closed-end funds which invest in them.

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

We also pay attention to the changes in the 10-year Treasury note. The municipal bond closed-end funds highly depend on its movements due to their relatively high duration. Currently, the 10-year Treasury yield is in a downtrend which is another stimulating factor for the municipal bonds.

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 announced their regular dividends:

  • Putnam Managed Municipal Income Trust (PMM) $0.0320 per share.
  • Putnam Municipal Opportunities Trust (PMO) $0.0531 per share.
  • Neuberger Berman Intermediate Municipal Fund (NBH) $0.0624 per share.
  • Neuberger Berman California Intermediate Municipal Fund (NBW) $0.0448 per share.
  • Neuberger Berman New York Intermediate Municipal Fund (NBO) $0.0393 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.
  • DWS Strategic Municipal Income Trust (KSM) $0.0475 per share.
  • DWS Municipal Income Trust (KTF) $0.0425 per share.

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

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. Despite the positive week for the benchmark, the closed-end funds did not increase their Z-scores. To use appropriately the statistical edge, I try to combine it with an attractive discount in order to review some of the participants as potential "Long" candidate.

Currently, BlackRock Municipal Bond Trust (BBK) and BlackRock MuniYield Arizona Fund (MZA) are the funds which meet my requirements. I am not going to recommend all of the other funds. Even though, Invesco Advantage Municipal Income Trust II (VKI) and BlackRock MuniHoldings Investment Quality Fund (MFL) have attractive discounts and offer relatively high yields, you will notice the worrying situation about their earning/coverage ratios. In short, I think they will not be able to maintain the current dividend and pretty soon we may see dividend cuts. The market participants noticed it and this is one of the main reason why they are traded at negative Z-scores.

Based on the statistical approach, BlackRock MuniYield Arizona Fund is one of the most undervalued funds from the sector. Almost all of the assets from the portfolio of MZA are from issuers located in Arizona. "Education" and "Utility" sector have the biggest weight in the portfolio and the main part of the investments is labeled as "AA" and "A" ratings.

Source: Fund Sponsor Website

In December, the dividend was decreased from $0.0520 to $0.0470 per share. This is one of the main reasons why the price fell and the fund is currently trading at 5.09% discount. The current yield is 4.10% and the yield on net asset value is 3.89%.

BlackRock Municipal Bond Trust has a current yield on the net asset value of 4.03%, and the current yield on price is 4.53%. Its Z-score of -0.50 point is accompanied by an attractive discount of 10.91%. Its earning/coverage ratio is 99.08%, but I still do not see a reason to worry about it. The fund has a positive UNII/Share balance of $0.048 per share which can be used.

2. Highest Z-Score

Source: CEFConnect.com

On the other hand are the closed-end funds sorted by their highest Z-score. From a statistical point of view, they should be overpriced. In the current market environment when the sector is very strong, it is very difficult to say which of the Munis are overpriced. Yes, the Z-scores are high but they are still traded at discounts. My simple recommendation is to play the game smart and when some of your long positions are traded at Z-score above 2.00 points close it and buy some of the funds which have a lower statistical parameter. The risk/reward ratio is not in your favor when you hold statistically overpriced funds.

Last time, we saw BlackRock MuniYield Quality Investment Fund (MFT) on the first position with a Z-score of 2.80 points. I recommended you to close your long positions and to re-allocate your funds in some of its peers. The latest earnings of the funds are not enough high to cover the dividend, and if there is no improvement, we can expect dividend cut pretty soon. On a weekly basis, the price of MFT fell by 1.00% and it is among the worst performers of the weeks.

The average one-year Z-score in the sector is 1.05 points. Last time, the average Z-score of the municipal sector was 1.06 points.

Source: CEFConnect.com

3. Biggest Discount

Source: CEFConnect.com

It is interesting to mention that only one of the municipal bond closed-end funds had a decrease in its net asset value on a weekly basis. The above funds are the ones with the highest spread between their price and net asset value. As we see, this sector still provides us with many closed-end funds traded at an attractive discount.

AllianceBernstein National Municipal Income Fund (AFB) is one of the funds which caught my eye. It is traded at 12.70% discount and has a relatively low Z-score of -0.10 point. The current yield of the fund is 4.21%, and based on the latest earnings report, we see that its dividend is fully covered. Based on the discount/premium metric, I find AFB as undervalued compared to its peers.

Source: CEFdata.com

Source: CEFdata.com

4. Highest Premium

Source: CEFConnect.com

Although we recently saw dividend cuts for many of the PIMCO funds, they continue to be traded at high premiums. 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. However, behind each investment and trade should be a justified reason and logic. My research shows that PIMCO California Municipal Income Fund (PCQ) may be a risky investment at that point of time due to the potential dividend cut which can be expected.

Also, 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

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 the same.

Source: CEFConnect.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 5.07%.

I think PIMCO New York Municipal Income Fund II (PNI) deserves attention. PIMCO fund traded close to its net asset value, and at negative Z-score may be reviewed as potential "Long" candidate.

6. Highest Distribution Rate:

Source: CEFConnect.com

The table shows the funds with the highest distribution rate on price. The average yield on price is 4.42%, and the average yield on net asset value is 4.15%. An important notice which I would like to make here is to be rational and to include the earning/coverage ratio to your analysis. Some of the market participants invest in the funds which pay higher yields, but they do not take into consideration the risk of a potential dividend cut if the dividend is not covered by the earnings.

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 36.2%. 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.

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 19, 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.