BBN: Muni CEFs Not Immune To Risk-Off Sentiment
Summary
- The last few days of the trading week saw a sharp underperformance in muni CEFs.
- While we don't know the exact source of this price performance, we suspect it has to do with a rebalancing towards weaker CEF sectors.
- We find the taxable muni sector attractive on a number of valuation metrics.
- Within the sector, we particularly like BBN for its attractive yield, coverage and historic returns.
- This idea was discussed in more depth with members of my private investing community, Systematic Income. Get started today »
Moves across CEF sectors have been fast, brutal and somewhat counter-intuitive. Despite boasting positive and best NAV performance over the week, the taxable muni sector has seen its discount widen the most. In our view, the sector offers good value for both tactical and strategic reasons. We particularly like the BlackRock Taxable Municipal Bond Trust (NYSE:BBN) in the sector for its discount valuation, strong historic returns and solid coverage.
Benchmarking The Moves In Discounts
In the chart below we plot how the CEF sector discounts have moved over the previous week, highlighting the tax-free and taxable muni CEF sectors. For each sector, we baseline the discount at zero as of the previous Friday and plot the cumulative changes in discount through this past Friday close. The legend in the chart except for the 2 highlighted municipal sectors is sorted in order of the discount move.
What the chart shows is that apart from the utilities sector which has seen its discount tighten, all the sector discounts have widened. The range of widening has been between zero and nearly 10%. Interestingly, the sectors taking the most beating such as MLPs and equity sectors have not seen the largest discount widening. Instead, higher-quality fixed-income sectors like munis, limited duration, and preferreds have seen the greatest widening of their discounts.
Source: ADS Analytics LLC, Tiingo
This dynamic, while counter-intuitive, is actually not all that unusual. The explanation may lie in tactical and strategic rebalancing. The sectors that have performed the worst in overall price terms may offer the most attractive tactical opportunities for investors who believe that the sell-off is overdone and who expect a V-shape market recovery. Unless they have spare cash, however, those investors are going to dump the sectors that have held up the best in price terms to reallocate to sectors that have performed the worst. In other words, sectors on the right hand side of the chart below will be sold and sectors on the left hand side of the chart will be bought. This is actually what we see as muni discounts have widened the most and MLPs and utilities the least.
Strategic rebalancing can work in the same way. Investors who wish to maintain the same percentage allocation to different sectors will sell the best-performing sectors in price terms and buy the worst-performing sectors.
Source: ADS Analytics LLC, Tiingo
So, while over the first three days of the sell-off, munis outperformed other sectors in their discount moves, over the last couple of days they underperformed, particularly the taxable sector. This suggests that over the last two days of the week, as some sectors moved into double-digit losses, municipal CEFs may have been used to raise cash in order to move into the underperforming sectors.
All of this is just a theory of course. It makes sense to us but it could be just a small part of the broader story which can also involve margin call pressure or stop-loss motivated selling.
Where's The Value At?
Of course just because these two sector discounts have moved the most doesn't necessarily make them attractive on a valuation basis. Let's take a look at their long-term valuation metrics. On a discount percentile basis which is calculated since 2000, these two sectors are below the all-sector average. The same holds true for the 1-year and 5-year z-scores.
Source: Systematic Income CEF Tool
Now that we know that the two sectors have underperformed in discount terms over the past week and look attractive on a number of long-term metrics, let's see how they performed in context of the last 5 years.
Source: Systematic Income CEF Tool
This chart tells us a couple of things. First, the moves in the taxable sector have been larger than in the muni sector which is in line with the relative price volatilities of the two sectors. Secondly, historically the municipal sector discount used to trade at or tighter than the taxable sector. More recently this behavior switched and the discounts of the two sectors are now again very close, reestablishing the previous pattern. Thirdly, the historic discount drawdowns have been around 10-15% for both sectors so recent moves to date are on the lower side of this range.
Long Duration Now, Really?
Given the record low risk-free yields on offer with the 10-year Treasury yield having fallen 0.5% just in the month of February, does holding taxable munis even make sense? In our view there are several reasons to keep an allocation to this area of the market. First, CEF distribution rates in the sector are respectable and in the range of 5-6%, buoyed by wider discounts and lower leverage costs. Secondly, as a tactical play the sector is currently attractive. And thirdly, any further deterioration in the market or macro environment should continue to support high-quality assets, at least on an NAV basis, despite low current yields.
An Opportunity In BBN
The Taxable Municipal Bond Trust is a $2.4bn total asset muni fund with a mandate to allocate at least 80% to the taxable sector. The fund has a 0.87% management fee and is trading at a current yield of 5.48% and a 9.63% discount - the widest in the sector. The fund holds all but 7.25% of its portfolio in investment-grade assets.
Oddly enough as of Sunday morning CEFConnect does not show the updated data for Friday close for this and other funds, making it difficult for investors who rely solely on the site to make their allocation decisions ahead of the Monday open.
The fund's discount is attractive on an absolute basis, standing at a 7th percentile as well as sector-relative basis with a discount sector spread percentile of 7% as well. 1-year and 5-year z-scores of -5.3 and -1.9 round out the attractive valuation story.
Source: Systematic Income CEF Tool
Distribution coverage of the fund has held up relatively well despite ongoing calls in the sector. Part of the reason in our view has to do with the prevalence of make-whole rather than optional calls in the taxable sector which we describe in our previous article. The fund doesn't have the highest current yield in the sector but it does boast the highest covered yield.
Source: Systematic Income CEF Tool
UNII as a ratio of monthly distribution has grown in the past few months as well.
Source: Systematic Income CEF Tool
The fund's historic NAV returns have been the highest in the sector over various time frames though this is in line with its historically higher NAV volatility and price drawdowns.
Source: Systematic Income CEF Tool
Conclusion
We don't know how much longer the current sell-off has to go. However, at current levels, the taxable municipal sector looks attractive as a tactical and strategic allocation. Within the sector we particularly like BBN which boasts a combination of attractive discount valuation, high covered yield and strong historic returns.
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This article was written by
ADS Analytics is a team of analysts with experience in research and trading departments at several industry-leading global investment banks. They focus on generating income ideas from a range of security types including: CEFs, ETFs and mutual funds, BDCs as well as individual preferred stocks and baby bonds.
ADS Analytics runs the investing group Learn more.Analyst’s Disclosure: I am/we are long BBN. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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