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.
Although the past week was positive for the stock market and the riskier assets, we did not see an abandonment from the safer asset classes such as municipal bonds. Some of the market participants continued to prefer the safer side of the coin after the bad jobs report. On Friday, after the U.S. government said the economy added far fewer jobs than expected during the month of May, the 10-year Treasury yield dropped below 2.06% which is its lowest level since September 2017.
Source: CNBC.com, US 10-Year yields
On a weekly basis, the main index iShares National AMT-Free Muni Bond ETF (MUB) increased its price by $0.01 and finished the Friday session at $112.88 per share. It is important to mention that the ex-dividend date of the main index was on Monday and it distributed a monthly dividend of $0.2403 per share.
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.
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 regular dividends:
- DWS Strategic Municipal Income Trust (KSM) $0.0475 per share.
- DWS Municipal Income Trust (KTF) $0.0425 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.
- Dreyfus Municipal Bond Infrastructure Fund (DMB) $0.0530 per share.
- BlackRock Municipal Income Investment QualityTrust (BAF) $0.0585 per share.
- BlackRock Municipal Income Investment Trust (BBF) $0.0580 per share.
- BlackRock California Municipal Income Trust (BFZ) $0.0445 per share.
- MFS California Municipal Fund (CCA) $0.0335 per share.
- Nuveen Intermediate Duration Municipal Term Fund (NID) $0.0425 per share.
- Invesco Advantage Municipal Income Trust II (VKI) $0.0450 per share.
- Eaton Vance California Municipal Income Trust (CEV) $0.0446 per share.
- Eaton Vance Municipal Bond Fund (EIM) $0.0429 per share.
- Eaton Vance New York Municipal Bond Fund (ENX) $0.0415 per share.
- Eaton Vance California Municipal Bond Fund (EVM) $0.0395 per share.
- Eaton Vance New York Municipal Income Trust (EVY) $0.0433 per share.
- PIMCO California Municipal Income Fund II (PCK) $0.0350 per share.
- PIMCO California Municipal Income Fund (PCQ) $0.0770 per share.
- PIMCO Municipal Income Fund (PMF) $0.0597 per share.
- PIMCO Municipal Income Fund II (PML) $0.0650 per share.
- PIMCO Municipal Income Fund III (PMX) $0.0507 per share.
- PIMCO New York Municipal Income Fund (PNF) $0.0530 per share.
- PIMCO New York Municipal Income Fund II (PNI) $0.0400 per share.
- PIMCO New York Municipal Income Fund III (PYN) $0.0355 per share.
- PIMCO California Municipal Income Fund III (PZC) $0.0418 per share.
1. Biggest price decrease
2. Biggest price increase
Review Of Municipal Bond CEFs
1. Lowest Z-Score
I would like to start our review with the fact that all of the municipal bond closed-end funds reported an increase in their net asset values on a weekly basis. Compared to the previous time, we do not see a significant change in the Z-scores of the funds from the sector. As you know, the Z-score shows us how many times the current discount/premium deviates from its mean for a specific period.
Pioneer Municipal High Income Advantage Trust (MAV) has the lowest statistical parameter from the area. This is a consequence of the slight weekly decrease of 0.28% in its price and the good performance of its net asset value which left in a green territory by 0.59%. The price of MAV is under pressure after the series of dividend cuts which we saw and mainly because they reflected significantly on the current yield of the fund and made it unattractive to the market participants.
Source: CEFAnalyzer.com, Pioneer Municipal High Income Advantage Trust
On the other hand, BlackRock Municipal Bond Trust (BBK) is a fund which is undervalued from my perspective. The reason behind its Z-scores is identical. In March, the dividend was decreased from $0.0635 to $0.0545 per share. However, the recent decrease in the price may be a good opportunity for us.
The current yield of the fund is 4.47%, and compared to its peers, it has traded at a much higher discount. Another positive is related to the solid past performance of the fund and its improving earning/coverage ratio. Over the past decade, the management team proved its quality by outperforming the sector by return on net asset value. The annualized return of BBK is 9.43% while the return of sector is 7.90%.
2. Highest Z-Score
Taking into consideration the strong performance of the sector over the past months, I am not surprised to find so high values of the Z-scores. Мy philosophy is simple when we talk about using the Z-score as a statistical indicator of overpriced funds. When the value of the statistical parameter is above 2.00 points without any fundamental reason, I will not review this fund as potential "Long" candidate. Furthermore, if we see a trend reversal in the sector, these CEFs with the highest Z-score will be my first choice when I am looking for potential "Sell" candidates.
Just because the sector is very strong now, my suggestion is just to stay away from the statistically overpriced funds. BlackRock Muni New York Intermediate Duration Fund (MNE) is the perfect example of what I am talking about. Its Z-score is 2.20 points just because its price has increased significantly over the first months of the year. At this level, the potential for capital gain is very limited and the yield on the price is 3.33% which is not competitive at all. If we take into account the unconvincing situation around its earning/coverage ratio and UNII/share balance, I will definitely recommend to avoid MNE at these price levels.
The average one-year Z-score in the sector is 1.11 points. Last time, the average Z-score of the municipal sector was 1.04 points.
3. Biggest Discount
Although the sector showed its desire for recovery, we still have many funds traded at pretty high discounts. My recommendation here is to find a fund traded at an attractive discount and relatively low Z-score. Depending on your investment horizon, take into account the average daily volume. If you are a trader, you do not want to include a liquidity risk to your plan. If you are a long-term investor, then the daily volume will not be so important, but then, you need to gather more info about the portfolio.
If you want to extend your investments in California, then BlackRock California Municipal Income Trust (BFZ) may catch your attention. It has relatively low Z-score of 0.40 points and one of the highest discounts in the area. The widened spread between the discount of BFZ and its peers you can easily notice on the above chart. The current yield of the fund is 4.07% and the dividend is fully covered by the latest earnings. The credit quality of BFZ is more than impressive as 57.69% of its investments are rated as "AA" rating.
Source: Fund Sponsor Website
4. Highest Premium
No doubt, the dividend of PIMCO California Municipal Income Fund (PCQ) and its potential decrease was one of the hottest topics lately. Once again, it did not happen and PCQ announced its usual dividend of $0.0770 per share. Nevertheless, the premium of 34.16% is extremely high and I consider an investment in PCQ at these levels as risky.
The average discount/premium of the sector is -6.08%. Last time, the average spread between the prices and net asset values of the funds was -6.12%.
5. Highest 5-year Annualized Return On NAV
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 5.30%. 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.
Nuveen Municipal High Income Opportunity Fund (NMZ) is an interesting fund which can be reviewed as a potential "Long" candidate. It is true that its Z-score is 1.40 points and it is traded at a slight premium but it has one of the highest current yields in the sector and one of the highest return on net asset value for the past decade. These positive facts are accompanied by earning/coverage ratio of 103.70% and UNII/share balance of $0.0400 per share.
6. Highest Distribution Rate:
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 4.36%, and the average yield on net asset value is 4.10%.
My recommendation here is to check also the earnings coverage ratio and the UNII/share balances of the funds which offer higher yields. I am saying it because if the earnings are not enough high to cover the dividend, it is possible to see a decrease in the distribution which is going to affect the yield of the funds, and it is very likely to see a decrease in its price.
7. Lowest Effective Leverage %
The average effective leverage of the sector is 36.1%. 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 June 09, 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 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.