This article was first released to Systematic Income subscribers and free trials on Apr. 20
Since the start of the year municipal bond yields have risen considerably on the back of persistent inflation and hawkish Fed rhetoric. This rise in yields, along with much improved muni / Treasury ratios and historically wide CEF discounts makes the tax-exempt CEF sector fairly attractive right now. In this article, we take a look at the MainStay DefinedTerm Municipal Opportunities Fund (NYSE:MMD), trading at a 5% discount and a 5.86% current yield.
MMD is run by MacKay Shields who is not a particularly large manager, running around $164bn of assets.
In some ways, the fund itself has a vanilla flavor - 73% in investment-grade bonds - slightly below the sector's 78% average. Its leverage is 36% - on par with the broader sector.
The fund has a sizable exposure to special tax bonds whose revenue is secured by specific designated taxes.
What’s unusual is its relatively low duration of 5.7 – vs. about 8-10 for the broader sector. This is something we will highlight below as well.
MMD has a current yield of 5.86% versus a sector average of 5.35%. Its distribution coverage of 96% is a touch below the 97% sector average.
Its covered yield (i.e. price net investment income yield or price NII yield) is 5.63% vs. 5.21% sector average. Covered yield is the level of net investment income that investors are earning at the current price of $17.42. The reason we like to focus on the covered yield is because it combines the fund's current discount and its underlying net investment income. Most income investors choose to focus on a fund's current yield (i.e. distribution rate) because it's more easily observable, however, the main problem with it is that it is purely discretionary and can misrepresent the fund's true level of underlying income generation capacity.
The two key drivers of covered yield are the fund's discount and its NAV NII yield. The fund's higher NAV NII yield profile of a 5.34% (vs. sector average of about 4.8%) is likely due to a combination of things such as its lower allocation to zero-coupon bonds, its slightly lower quality profile, its lower cost of leverage and a higher-coupon tilt with very few 4% coupon bonds. These factors should continue to allow the fund to generate an above-sector average level of income.
The fund's NII has been relatively stable over the past couple of years though it has moved lower over the last 5 years. We would expect NII to move lower from here due to the rise in leverage costs for the broader fixed-income CEF space.
Although the fund has maintained its distribution for the last 4 years or so, we cannot rule out a distribution cut. If this happens, however, we would look to add a position if we see the discount widen from current levels.
MMD has been one of the best-performing funds in the national tax-exempt CEF sector in total NAV terms (second in the last 5 years and fifth in the last 3 years). It has outperformed the sector by 1.1% and 1.5% per annum over these periods.
This strong absolute performance has also been matched by consistent and risk-adjusted performance as well.
Specifically, MMD has the highest consistency metric in the sector (%YRS NAV Outperformed metric in the table below) - it has outperformed the sector in 80% of the years in which it has been outstanding in total NAV terms - the highest metric in the sector.
And MMD has also delivered one of the highest risk-adjusted returns in the sector as well (Alpha metric in the table below). Some other funds, such as the PIMCO funds, that have delivered strong absolute returns look poor on this risk-adjusted metric.
We also like to check in on a metric we like to call COVID Resilience which measures a fund's performance from Feb to Aug 2020 - a period across which markets broadly speaking returned to their pre-COVID levels. Here, the fund has outperformed the sector by 1.6%, highlighting its relative resilience in periods of shocks.
The screenshot below from our investor CEF Tool captures these metrics.
As of this writing, MMD is trading at a discount of 5% vs. the sector average of 7.8%.
The national tax-exempt CEF sector discount has not historically traded wider of the current level for very long. This makes the broader sector allocation attractive in our view.
MMD has tended to trade at a higher valuation than the broader sector as the following charts show.
This is the case for a few reasons. First, its strong and consistent outperformance (in both absolute and risk-adjusted terms) discussed above means it simply deserves its higher valuation.
Secondly, its higher income generation ability. The fund's tighter discount only offsets about a quarter of its higher income level.
Thirdly, the fund's term structure (with an expected termination date in 2024) should keep its discount from widening more than the sector average given some likelihood that the fund either turns into an open-end fund (as discussed in its shareholder report), terminates or turns into a perpetual CEF but allows shareholders to exit at the NAV.
Overall, given these factors, the fund's discount looks attractive at the present moment. As the right-hand chart shows above, the valuation differential between MMD and the broader sector is on the lower side over the last 5 years, making it an attractive entry point, in our view.
It's also interesting to note that this month three different insiders bought around $300k of the fund. These purchases were done above the current price.
What could be driving the fund's historic outperformance and should investors expect this to continue?
One reason could be that it uses primarily tender option bonds or TOBs for its source of leverage. TOBs tend to offer the cheapest source of leverage which creates a smaller drag on the fund's expense profile. This does carry with it a greater risk of deleveraging, however. For instance, as we documented earlier, the PIMCO muni funds saw a deleveraging in their TOBs during the period of market dislocation.
One way we like to check the leverage resilience of a given fund is simply to check how the liability side of its balance sheet fared during the COVID crash. If we look at the two MMD shareholder reports that straddle March of 2020 (those for Nov-19 and May-20), we find that the fund actually increased their TOB borrowings $258m to $292m, pushing its leverage from around 35% to 40% - a fantastic call in retrospect given the extended rally in municipal bonds in the aftermath of the COVID crash. This allowed the fund to generate additional value for shareholders in a period where many funds locked in losses by cutting their borrowings.
The fund was also likely helped by its lower-duration profile which allowed it to conserve value on the way lower as we can see in the table below which shows its normalized total NAV return versus two other popular tax-exempt CEFs. This combination of a relatively low beta and leverage resilience means the fund is likely to maintain resilience during drawdown periods.
Overall, our impression is that the fund is especially nimble in responding to market conditions. We can see this in its leverage and borrowing increase as well as a rotation to higher-yielding bonds (highlighted in the May-20 report) during the COVID drawdown.
The fund also swapped its fixed-rate preferred shares in 2020 for floating-rate leverage instruments, taking advantage of low short-term rates and increasing its net income by decreasing its leverage cost.
We can also see it in its duration profile which has downshifted prior to the recent move higher in rates. From a yield curve perspective, a lower duration stance also makes sense. The flatter the curve the less of a yield pickup there is to be gained by moving further out the yield curve. This allows the fund to maintain a similar yield level to funds with a longer duration profile.
The fund's duration of just 5.7 is one of the lowest in the tax-exempt CEF sector. It is the primary reason, in our view, that the fund has outperformed the sector year-to-date (-11% vs -13.5%). Funds with a longer duration profile, such as the PIMCO tax-exempt funds which sport double-digit durations have been especially hurt - the PIMCO national tax-exempt trio are all down more than 16% in total NAV terms year-to-date.
The fund's lower duration stance is not just good from the point of view of NAV resilience year-to-date which is nice, but it also allows the fund more room to add assets. This is for the simple reason that a lower NAV leads mechanically to a higher leverage level, all else equal. The slower the drop in the NAV the slower is the rise in leverage and the more room a fund has to add assets at attractive levels.
We entered 2022 with a very cautious stance on the tax-exempt CEF sector. However, over the last few weeks, the valuation profile of the sector has improved tremendously. Not only have bond yields risen substantially but muni bond valuations (i.e. credit spreads and muni / Treasury ratios) have become much more attractive.
And although it's not quite "blood on the street" yet, muni bond flows have been negative for nine straight weeks - the kind of environment which often leads to longer-term outperformance.
At the same time, it's important to avoid catching a falling knife given the nearly straight line higher in Treasury yields. Nibbling at current levels while saving some dry powder in case we see significantly higher yields makes sense in the current environment.
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This article was written by
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Disclosure: I/we have a beneficial long position in the shares of MMD either through stock ownership, options, or other derivatives. 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.