Weekly Review: Municipal Bond CEFs - Another Flight To Safety

by: Arbitrage Trader

Once again, the investors preferred safer assets due to the uncertainty around the U.S. trade relations and the concerns about global economic growth.

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 past week was about to stay calm for the sector but on Friday we saw a strong buying impulse. The investors preferred the safer assets such as municipal bonds and closed-end funds which invest in them after the new decline of the stock market. On a weekly basis, the main index iShares National AMT-Free Muni Bond ETF (MUB) increased its price by $0.37 and finished the Friday session at $112.87 per share.

The flight to safety on Friday came after President Donald Trump threatened new tariffs on Mexico. The yield on the benchmark 10-year Treasury note continued to fall which left some room for the municipal bonds to increase their prices.

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.

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, Dreyfus Municipal Income (DMF) declared its dividend of $0.0350 per share with no change from the prior distribution.

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

The first criterion which is part of my analysis is the Z-score of the closed-end funds from the sector. It is a statistical approach which helps us to figure out how many times the discount/premium deviates from its mean for a specific period. Respectively if the Z-score is negative we can talk about a statistical edge to buy the funds. It is getting even better if we combine the statistical indicator with an attractive discount in order to review the fund as a potential "Long" candidate.

We still have nine CEFs from the sector which are traded at negative Z-scores. We have a new leader of the table in the face of Invesco Municipal Income Opportunities Trust (OIA). Аlthough it is traded at a slight discount this fund may be an interesting buying opportunity. The first reason is the solid past performance which is an indicator of the quality of the management team. Over the past decade, the fund outperformed its peers by return on the net asset value.

Source: CEFConnect.com

Currently, OIA offers 5.21% current yield and 5.16% yield on the net asset value. Both of the yields are attractive for this sector. The dividend of the closed-end fund is stable and the management team manages to keep the earnings/coverage ratio around the important border of 100%.

Source: CEFdata.com

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.

Delaware Investments National Municipal Income Fund (VFL) is a very good example of the power of Z-score. Last time, we saw VFL traded at 3.80 points Z-score. No doubt, this value of the statistical parameter is very high and can not be sustained for a long time. I recommended you to close and your long position in VFL and to find another bargain in the sector. On a weekly basis, the price of the fund fell by 1.63% even when its net asset value reported a gain of 0.34%.

The situation around BlackRock MuniYield Quality Investment Fund (MFT) and BlackRock Municipal Income Investment QualityTrust (BAF) raises a red flag for me. Recently, we saw a significant increase in their prices and now they are traded at Z-score above 2.00 points. Тhis is not the most worrying fact. If you check the earnings/coverage ratios of MFT and BAF you will see that the latest earnings were not enough high to cover the dividends and pretty soon we can see a dividend cut and decrease in their prices.

Source: CEFdata.com

Source: CEFdata.com

The average one-year Z-score in the sector is 1.03 points. Last time, the average Z-score of the municipal sector was 1.06 points.

Source: CEFConnect.com

3. Biggest Discount

Source: CEFConnect.com

We do track the performance of 137 municipal bond closed-end funds and the fact that only 2 of them reported a decrease of their net asset values is impressive. However, we notice another narrowing of the spread between the two metrics just because the prices rose more.

Many of the funds are traded at an attractive discount. I will highlight the fact 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 average discount/premium of the sector is -6.12%. Last time, the average spread between the prices and net asset values of the funds was -6.22%.

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. As you know, the earnings/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. No doubt, an eventual dividend cut will have a negative reflection on the price. So, it is not a bad idea to consider the closing of your long position.

If you have a long position in Eaton Vance National Municipal Opportunities Trust (EOT), 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. On top of that its earnings/coverage ratio is below 100%.

Source: CEFdata.com

Source: CEFdata.com

5. Highest 5-year Annualized Return On NAV

Source: CEFConnect.com

The above sample shows the funds which outperformed their peers. As you see, most of the participants are sponsored by Pacific Investment Management Company LLC, and these good results are the reason why the market participants are willing to pay a premium for them on a regular basis. The average return on net asset value for the past five years for the sector is 5.12%.

6. Highest Distribution Rate:

Source: CEFConnect.com

The average yield on price is 4.39%, and the average yield on net asset value is 4.13%. Of course, each of us wants to achieve a higher return, but you need to pay attention to the fundamental analysis and to avoid these ones which are threatened by dividend cuts.

No doubt, Nuveen Municipal High Income Opportunity Fund (NMZ) is a fund which deserves attention. It offers one of the highest yields in the sector and is very positive to notice that its dividend is fully covered by the earnings. On top of that, the UNII balance per share is in green territory. Also, the past performance of the fund is impressive. Over the past decade, the management team of NMZ managed to achieve one of the highest returns on net asset value in the sector.

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 June 02, 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 long position in NMZ 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.