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This article was first released to Systematic Income subscribers and free trials on Dec. 28.
Tax-exempt municipal holdings form a core of many income portfolios. In this article, we touch on the performance of the sector in the past year across several dimensions, highlight a number of key themes and discuss our stance. The sector continues to benefit from a strengthening credit environment as well as a supportive technical backdrop. The infrastructure bill with $550bn of new federal spending is a credit positive for state and local governments while net supply is expected to remain negative for the coming year and particularly over the start of the year which should support valuations.
Key Themes
A key theme that should be on the radar of muni investors, particularly those that allocate to CEFs is the likely rise in short-term rates over the next year and its knock-on impact on CEF leverage costs. The Fed has penciled in 3 hikes in the next year and the market consensus agrees with this estimate. Muni fund leverage costs tend to follow the SIFMA index which itself tracks roughly 2/3 x 1-Month Libor as it's a base rate for short-term tax-exempt securities. If the Fed completes three hikes by the end of next year, SIFMA should stand around 0.5%. What this means is that the rise in muni CEF leverage costs would eat up an equivalent of about a third to a quarter of the fund's leveraged asset yield (leveraged assets typically represent around a third of all total CEF assets).
This is not the end of the world but it is a sizable reduction in yield that is passed on to the fund's shareholders and will create a drag on fund NAVs. It also means that investors should be prepared for municipal fund distribution cuts, some of which are likely to occur preemptively - perhaps as soon as the Fed begins its hiking cycle which could happen as early as March.
The chart below shows that the tax-exempt CEF sector saw a respite from the longer-term downtrend in distributions in 2020 because of the sharp drop in leverage costs. And because the sector hiked distributions in response to this tailwind, there is no cushion left to absorb the coming reversal in leverage costs. Therefore, investors should expect the sector to resume its longer-term falling distribution trend that we saw prior to 2020. The distribution trend should be further stressed by the higher prevalence of lower-coupon municipal bonds as the market shifts away from the 4-5% coupon convention, which may have made sense 10 years ago but is just plain odd today.
Source: Systematic Income CEF Tool
Another important theme is, the overall low level of yields. It is tempting to look at the historical returns of the municipal CEF sector and expect the same type of performance going forward. For instance, the 5Y total NAV return of the muni CEF sector is 6.1% which is very respectable for what is a very high-quality sector.
However, let's disaggregate this impressive return. The yield of the longer-term municipal bond index 5 years ago was about 3.31% which then moved lower to 1.59% today. If we do a back-of-the-envelope 5Y return, what we get is roughly the initial starting yield of 3.31% + the 1.72% drop in yield x duration of around 6 = 5.37% which adjusted with the average leverage of about 35% = 8.26% less total fees (including leverage costs) of roughly 2% gets us to very roughly 6.3% which is not a million miles away from the 6.1% actual 5-year annual total NAV return.
Source: S&P
What does this mean going forward? Well, 1) our starting yield is now around 1.59% rather than 3.31% 5Y ago and 2) we should no longer expect a continued tailwind of lower yields for the simple reason that if yields fall by the same amount over the next 5 years as they did in the last 5 years then municipal yields will be -0.13% at the end of 2026 which seems unlikely.
Leverage costs today are lower than they were on average in the last 5 years, however, 1) they cannot compensate for the drop in yields and 2) they are slated to rise next year. What this suggests is that investors should probably pencil in returns in the low single digits for funds that allocate to higher-quality munis.
With apologies to Charles Dickens, the chart below is the "ghost of municipal future yet to come". It shows the total NAV return in the second half of 2021 - a period when municipal yields were broadly flat. It shows that the median investment-grade focused CEF total NAV return (blue line) was 0.5% over this period (about 1% in annualized terms). In short, the returns over the next 5 years, at least for the high-quality muni CEF space, are much more likely be closer to 1% than they are to be closer to the 6% that we saw over the last 5 years.
Source: Systematic Income CEF Tool
A third we will highlight is the "safety" theme. Many investors are allocated to municipal funds because municipal bonds are, rightly, viewed as being of very high-quality, in aggregate. However, we think investors should expand the concept of "safety" from a one-dimensional focus on credit-quality to a multi-dimensional focus that incorporates other key features. Specifically, investors should incorporate duration, investment vehicle, leverage level and leverage composition, in addition to credit quality in their concept of "safety".
Municipal bond funds tend to feature some of the highest durations across the entire fixed-income space. This means that in a scenario of significantly higher interest rates, municipal bond funds will not feel particularly "safe". The chart below shows the current dislocation between the level of core inflation and the 10-year Treasury yield. Our base case is that this unusual gap between the two metrics is much more likely to close by inflation moving lower than Treasury yields moving higher. However, the risk of significantly higher Treasury yields cannot be ruled out. This suggests that investors should take a look at shorter-duration high-yield municipal funds which can perform better in a higher rate scenario without sacrificing yield.
Source: Systematic Income Funds Tool
As far as the investment vehicle factor is concerned, investors have the choice of CEFs, ETFs and mutual funds when they allocate to municipal bond in fund format.
CEFs tend to see periodic bouts of discount widening on the order of 5-10% which can be quite painful for investors. It is also worth noting that current discount valuation is fairly elevated and the next 5% move in discounts is much more likely to be lower (i.e. wider) than higher (i.e. tighter).
Source: Systematic Income CEF Tool
It follows that open-end funds are more attractive "dry powder" assets than CEFs. In open-end funds, investors have the pick of ETFs versus mutual funds. The chart below shows the Vanguard Tax-Exempt Bond Index ETF (VTEB) and the Vanguard Tax-Exempt Bond Fund Admiral Shares (VTEAX). The first is an ETF and the second is a mutual fund but they invest passively in the same index - the performance is nearly identical as we can see below with the except of the difference in drawdown in 2020.
Source: Systematic Income
Let's zoom in a bit - here we can see that over a couple of weeks the ETF traded at levels around 10% lower than the mutual fund at the worst of the crisis in March of 2020. Holders of mutual funds can, not only transact at the NAV, but can also do it without worrying about crossing bid/offer or finding liquidity in a tough market. This liquidity option can make mutual funds a much better dry powder option than even ETFs (not to mention CEFs). Ultimately, the better a fund is at maintaining investor capital the greater amount of total return and income the investor can generate by reallocating to funds going through sharper drawdowns.
Source: Systematic Income
Moving onto leverage - the risk of higher leverage levels is obvious. The higher the leverage the more sensitive a given CEF is to a drop in the market. The less obvious risk of a higher-leveraged fund is that higher leverage increases the risk of a forced deleveraging. A good example of this is the action in the historical NAV return of PIMCO municipal funds which tend to run at significantly higher leverage levels than the broader sector. A sharp deleveraging such as the one highlighted in the chart below can make it very difficult to make up in the future. This doesn't mean that investors should avoid leveraged funds, however, they should take this risk onboard. As leverage costs begin to rise next year, the incremental yield of leveraged assets passed on to investors will decrease and the risk/reward of running a fully leveraged position will worsen.
Source: Systematic Income
Finally, a factor related to leverage is what we call leverage composition. Municipal funds have different leverage instruments which have different risks and costs. Funds that rely to a larger extent on tender option bonds have a more fragile leverage profile and are more liable to deleverage. This is precisely what we saw happen in the sector in aggregate and as exemplified by the PIMCO muni CEFs which deleveraged their TOB positions but not their variable preferreds.
Bringing all these factors together means that a more holistic perspective on "safety" should lead to fewer surprises down the road if and when we see some bumps along the way.
Finally, it's important to touch on tax-exempt valuations. The current valuation picture relative to the last 5 years is pretty rich. We can see this in the PIMCO chart below.
Source: PIMCO
AllianceBernstein shows valuations for both higher-quality and lower-quality investment grade bonds, both of which look expensive.
Source: AB
Nuveen has a hard-to-read chart which could benefit from both a different color palette as well as a yield ratio cap around 150%. In any case, this chart shows that while muni valuations are indeed rich over the last 5-10 years, they are less rich over the longer timeframe.
Source: Nuveen
Performance Review
The chart below from Nuveen shows the performance of the various tax-exempt index sub-sectors (across different maturities as well as high-yield / unrated munis vs. the broader sector) up to the end of October.
Source: Nuveen
This picture makes a lot of sense, particularly, for the ex-High Yield sub-sectors because municipal (and other fixed-income performance) can be disaggregated into parts: the starting yield and the change in yield. The starting yields of the broader municipal sector were on the order of 1-2% at the start of last year and they have not changed appreciably since then. Hence, total returns for the year are going to be on the order of 1-2%.
High yield muni sub-sectors stand out because of their higher initial starting yields and the fact that their yields have fallen much more over the past year, which has boosted returns.
The picture below, also from Nuveen, is a nice reference and shows the yield and duration breakdown of various "credit" sectors. The tax-exempt sectors should obviously be adjusted by the individual investor's tax situation for an apples-to-apples comparison.
Source: Nuveen
The performance of various indices is one thing - let's now take a look at how actual investment vehicles have performed across the tax-exempt space. When we do this we like to split out performance of funds that allocate across primarily investment-grade rated bonds and those that allocate across both investment-grade and high-yield / unrated bonds.
Pardon the busy chart below - it highlights how various investment vehicles have performed across the investment-grade tax-exempt universe by total NAV return. Blue bars are CEFs, green bars are mutual funds, red bars are passive ETFs and black bars are active ETFs. There are also four lines representing the median return for each type of investment vehicle.
Source: Systematic Income
The key takeaways from this chart is that 1) leveraged investment vehicles like CEFs have outperformed, primarily due to their higher underlying income levels (owing primarily to a longer duration profile and leverage), 2) actively-managed vehicles such as mutual funds and active ETFs outperformed their passive counterparts.
Now let's take a look at the universe of funds that also allocate to high-yield and unrated tax-exempt bonds.
Source: Systematic Income
The takeaway here is that high-yield / unrated focused funds have strongly outperformed the investment-grade focused part of the market. We often get feedback to the effect of - "why would I hold lower-quality tax-exempt funds if they give me the same yield as those that allocate to primarily investment-grade bonds?".
As we have highlighted many times before, the reason CEF yields are very similar across both types of sub-sectors has to do with the coupon convention of the municipal sector where bonds are typically issued with coupons of 4-5% regardless of their underlying yields. For instance, you will often see a 4% coupon bond issued at a 1.5% yield and a price of $125. Because tax-exempt bond coupons are not representative of their underlying yields (i.e. yields-to-call or yields-to-maturity) it makes it look like tax-exempt CEFs all have pretty similar "yields" of around 4%. The fact that the two sub-sectors had substantially different performance highlights that they are not "the same".
Another takeaway from the chart is that actively-managed vehicles also outperformed. The median mutual funds outperformed passive ETFs only marginally, however, on an average basis, the outperformance was significantly higher.
Another, somewhat tongue-in-cheek, performance comparison we like to run is how various muni CEF houses did this year. The color-code legend is the following: Nuveen = red, PIMCO = green, BlackRock = black, Eaton Vance = yellow, MFS = maroon, BNY Mellon = white, Invesco = cyan.
Source: Systematic Income
Nuveen CEFs clearly outperformed this year as did MFS and PIMCO funds with Eaton Vance and BlackRock putting in middling performance. It's important to highlight the fact that one reason Nuveen funds did well this year, on average, was that Nuveen has the largest number of funds focused on the high-yield / unrated sub-sector and this is the reason why many of its funds outperformed (6 of the top Nuveen performing funds focus on this sub-sector).
Stance and Takeaways
Our Municipal Income portfolio continues to favor a barbell stance of high-yield focused CEFs as well as higher-quality focused open-end funds. The total return of the portfolio for 2021 is closing in on a double-digit return as the chart below shows. This figure exceeds the total return of the CEF municipal sector over the same period despite carrying significantly lower embedded leverage with 30% of the portfolio allocated to mostly unleveraged ETFs and mutual funds.
Source: Systematic Income Income Portfolios
The chart below highlights the performance of funds that have remained with the portfolio since inception (red bars) in the context of the broader CEF tax-exempt sector. The CEF sleeve alone delivered a return of around 12% this year.
Source: Systematic Income
We continue to hold exposure to high-yield focused funds for a few reasons. First, despite their high-yield focus, they hold significant exposure to higher-quality bonds as well. In fact, many of these funds hold investment-grade bonds as a majority allocation which allows these funds to source financing at competitive levels as well as provide fund managers with a broader investment mandate, creating a wider scope for alpha generation.
Secondly, high-yield tax-exempt bonds continue to offer some of the highest yields per unit of duration in the fixed-income space as the chart below shows.
Source: Systematic Income
Thirdly, high-yield focused funds have a lower empirical duration than investment-grade focused funds. This is because high-yield bonds have a larger credit spread cushion with which to absorb higher interest rates.
Fourthly, although high-yield tax-exempt bond yields have compressed significantly in the past year as the chart below shows...
Source: Systematic Income
...the ratio of high-yield to investment-grade munis remains attractive.
Source: Systematic Income
Across the CEF space we continue to like a number of Nuveen higher-yielding focused funds. Over the past year, our highest allocation has been in the Nuveen Municipal Credit Opportunities Fund (NMCO) which has delivered a performance of 29.4% - beating the broader sector by 20% (while beating the sector in NAV terms by a more modest 13%). The fund remains attractive at a 4.73% current yield and a flat premium though we clearly don't expect it to repeat the performance of 2020.
Coverage has also remained steady and UNII has been on an upward trajectory.
Source: Systematic Income
We also continue to like MFS tax-exempt CEFs. These funds trade at some of the largest discounts in the sector despite below-average fees and performance that has either beaten the sector over the longer-term or matched it. These funds don't find much demand because of their tendency to frequently adjust distributions and they have been trimming them over the past few months.
A fund like the MFS High Yield Municipal Trust (CMU) has matched the sector performance over the past 5 years in NAV terms but continues to offer two levels of margin of safety. First, it features distribution coverage of around 105% which is about 10% above the sector average. And secondly, it trades at a very attractive valuation of a 7% discount versus a 1% average discount in the sector. The fund currently trades at a 4.2% current yield. Although this is about 0.2% below the sector average, it's important to remember that the fund's net investment income yield on price is actually above the sector average because of its significantly higher coverage and its discount.
Source: Systematic Income CEF Tool
On the dry powder / open-end fund side of the portfolio barbell, we continue to like the Xtrackers Municipal Infrastructure Revenue Bond ETF (RVNU) which is the second best performing passive ETF in the sector and has also beaten most active ETFs and most mutual funds. The fund is focused on the infrastructure revenue bond sub-sector, features a low fee of 0.15% and a very high-quality profile with allocations primarily to AA and A-rated bonds.
Finally, in our view, the best way to mitigate the impact of low prospective returns due to a low yield environment is to tilt to funds with a history of consistent alpha generation. Additional alpha returns can "top up" a more modest beta exposure to the sector.
We use two alpha metrics in our analysis - described in the linked article above. This is what the alpha chart looks like for the tax-exempt CEF sector - the green square highlights the part of the sector with a stronger alpha profile. Many of these funds continue to be part of our Muni Income Portfolio.
Source: Systematic Income
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