Muni CEF Update April 2022: Still No Capitulation But Cuts Have Started Up

Apr. 28, 2022 7:00 AM ETBTT, DMB, EVN, KTF, LEO, MHF, MMD, MVF, MYI, NAD, NEA, PMF, VPV24 Comments

Summary

  • Muni CEFs have been beaten up so far in 2022. This is the worst 3-month period in a non-recessionary environment for 3 decades.
  • In prior periods of rising rates it has been a good time to get in as muni bonds tend to be resilient over time.
  • While muni CEFs are much cheaper today than they were three months ago, the rapid decline in the NAVs keeps me on the sidelines.
  • For those looking to add, we have several good options. As always, we look at distribution safety above all else but couple it with an attractive valuation.
  • Picks: MMD, NEA, LEO, MVF, EVN, VPV, PMF.
  • I do much more than just articles at Yield Hunting: Alt Inc Opps: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
Municipal bonds is shown on the business photo using the text

Andrii Dodonov/iStock via Getty Images

(This article was first published for members of Yield Hunting on April 12, 2022. All data herein is from that date.)

We continue to be cautious on municipal securities and the price action today - along with the rise in long-term rates and curve inversions - is indicative of that stance. Additionally, the valuation of the sector isn't where we would need it to be in order to be able to offset some of the stronger risks and headwinds.

In this report, we will discuss how to think about the muni space for long-term income-oriented investors. Some investors think of muni investments as a short-term trade but that is not what they are built for. We will go into the way to frame these investments in your portfolio.

The market remains a precarious one and I continue to be in a wait-and-see mode. I have made several swaps as you can add significant value through tax-loss harvesting but as for new money, that is sitting on the sidelines.

Top Buys For Valuation And Distribution Stability:

(1) Mainstay MacKay Defined Term Muni Opp (MMD), yield 5.72%, discount -5.6%.

(2) Nuveen AMT - Free Muni Credit (NEA), yield 4.97%, discount -8.8%

(3) BNY Mellon Strategic Muni (LEO), yield 5.12%, discount -8.6%

(4) Blackrock MuniVest (MVF), yield 5.16%, discount -10.5%

(5) Eaton Vance Municipal (EVN), yield 5.05%, discount -9.04%

(6) Invesco PA Value Muni (VPV), yield 5.02%, discount -13.3%

(7) PIMCO Municipal Income (PMF), yield 5.7%, premium +0.2%

The State Of The Muni Market Today

Municipal bonds are very stable investments in most years. However, there is the odd year every once in a while when rate expectations unexpectedly rise beyond what the market was anticipating. We saw it last in late 2018 and before that in 2013. Typically, these are good years to buy in.

We started 2022 with a very strong fundamental setting after the last round of fiscal stimulus which allocated substantial funds for state and local municipal budgets. Defaults are not an issue which is why we pushed high yield munis starting last year.

However, rising rates drove municipal bond performance to their worst return in 40 years. Through March 31st, the sector experienced a -6.4% total return as muni fund flows continue to be negative.

It should be noted that the muni market and interest rates do not move with a perfect correlation. This is primarily because munis are an illiquid asset class with less than 2% of the outstanding bonds trading at all on a given day. Thus, so few bonds are repriced accurately to fully reflect the changes in the rate market.

The chart below shows that even over a long history of Fed rate policy changes across a variety of market cycles, municipal bonds have consistently delivered positive returns. A contributing factor is that the tax exemption is valuable in all rate and tax environments to many types of investors. The chart depicts that looking back over the last 26 years, munis have delivered negative returns during only four of those years. Throughout those periods, both rates and credit concerns were working together to drive down all fixed income, unlike the current situation.

Yearly Muni Index Returns and Changes in Fed Funds Rate

TCW Investments

Outflows remain the name of the game with 7 consecutive weeks of money flowing out of the space amounting to $2.0 billion in the last week alone. More than $108B in market value has been lost since the start of the year. Bloomberg noted that the amount of bonds out for bid (meaning that they are attempting to be sold) stood at $2.1B, a level not seen since the start of the pandemic.

muni fund flows

Refinitiv

Thirty-year AAA Munis are trading at 106% of the yield on the same US treasury, the highest since late 2020. That ratio hit a low of 67% in June 2021.

How High Can Rates Go?

Real interest rates are severely negative which means that the sky is really the limit in how high long-term rates can rise. But in reality, there is a limit as inflation should subside a bit and most think that inflation will ease as economic growth wanes, supply issues are rectified and the stimulus effects from the last two years are faded.

nominal vs real rates

Bloomberg

The path of inflation will be the big unknown for this year. It will likely drive a lot of what happens in risk assets as it will largely dictate what the Fed does on interest rates and the balance sheet reduction.

A lot of what happens in the next nine months for the 10-year yield also hinges on economic growth. 2022 predictions are much lower than the stimulus infused +6.9% GDP growth we saw in 2021. That +6.9% growth was the fastest since 1984. Most expect GDP to come in below 3% for all of 2022.

The range of expected outcomes for this year for both GDP growth and the 10-year yield is exceptionally wide, showing the amount of uncertainty. The key is how fast the US can shake off the negative effects of the supply-chain issues and high inflation. We've seen some hints of improvement lately but only small improvements. Consumer spending hasn't been dented at all so far but that is likely to start changing.

The chart below shows how the market has consistently understated its forecasts for inflation. If this continues then the market may also be understating the tops of interest rates.

CIO weekly commentary chart 1

Nuveen

Muni CEFs Get Hit But Discounts Aren't Overly Cheap

In a recent article titled, "Is It Time To Add To CEFs Or Not?" the first point of several was to buy the NAV, not the discount. Before you consider the discount as cheap and an opportunity, you must assess the potential NAV performance over the next year or two.

Even if there is a wide margin of safety with a massive discount, if the NAV is in decline then the discount isn't much good. As I wrote:

If you buy a fund that has a wide discount but the NAV is in free fall, the discount doesn't really matter. Sure, you are getting a few percent of extra cushion and some additional yield, but that could be wiped out quickly in a falling NAV environment like we are in.

On Wednesday, March 30th, I noted that the muni CEF space was trading at discounts that measured about -4.8% which was slightly tighter than the long-term average. In other words, about 46% of the time, discounts were tighter. To me, that is not a level that screams massive margin of safety.

In prior sharp rising rate environments like in 2018 and 2013 before that, the percentage of times when the discounts were tighter was much larger. In fact, in late 2018, the number reached 99%. In other words, in nearly every prior instance going back to 1996, the discount was much narrower.

I used the following chart in that Note showing that the Fed Funds is rising 3x faster this tightening cycle (or at least it is expected to) compared to 2018. If rates are rising faster, and long-term rates are also rising faster (but are just as flat) I've been surprised that we haven't seen muni discounts really blow out.

Rates

BDC Buzz

Discounts bottomed out around -6.5% and haven't sold off more. Again, I've been surprised by this given what rates have done. You can see the prior rate-hiking environment on the far -left of the below chart (which starts on January 1, 2019). Discounts were wider than what we saw in the depths of the Covid decline.

Discounts

Alpha Gen Capital

I've been waiting for those discounts to widen out towards or wider than that black line on the chart above.

Update: Since I wrote the above, muni discounts have widened out significantly. We are now at the 84th percentile. However, I'm waiting for the 90th to be interested in adding new money to the space. Not only that but I would need to feel comfortable thinking that long-term rates were close to their top.

avg discounts

RiverNorth

NAVs Are Too Weak To Get In Here

The yield on the 10-year recently hit 2.77%, which is pushing down anything with duration down in price. The inverse relationship between rates and prices are driving down the NAVs of all municipal bond funds.

The chart below shows Nuveen AMT-Free Muni Inc (NEA), the term-trust BlackRock Municipal 2030 Target Term (BTT), and a non-leveraged fund, Western Asset Municipal Inc (MHF). For one, you can see the effect of the leverage on the NAV performance. However, we can also see that the leverage is NOT the only reason that these NAVs are down.

chart

Ycharts

As the 10-year continues to rise, the NAVs will continue to fall. I've seen commentary on SA stating that the continuous drop in the value of these muni funds will cease as they replace lower-yielding coupons with higher-yielding ones. That is false. Coupons are going up. Yes. But that will not come close to offsetting the duration or interest rate effects.

Retail investors scooped up munis last year with 1% yields and now don't want to touch them at 2% to 3% yields. We always see this in all areas of the market as outside factors are driving investors away. The contrarian in me wants to load up here - but I'm waiting impatiently.

For now, with the Fed in extremely aggressive rate-hiking mode, and the 10-year appears poised to only head higher. In fact, Goldman came out and said that they expect it to hit 3.5% in the next six months.

More pain could be coming. The paltry 2% yields on the individual muni bond side and even the 4.5%-5%+ (tax-free) on the CEF side won't be enough to offset another - potentially - 5% to 10%+ decline in NAV.

Distributions Are Starting To Break, There's Many More To Come

We have seen 24 cuts to muni CEF distributions already in April. That compares to 6 in March, 1 in February and 3 in January. That does seem like a lot but there are 119 municipal bond CEFs in the market. And many of them, like the MFS funds, micro-adjust the distributions almost monthly.

In all of last year, there were just 30 muni CEF cuts and only 21 that amounted to more than 2%.

We are going to be going that monthly it appears, at least for the next few months as sponsors right-size their distributions for the new leverage costs and the current environment.

The question will be if fund sponsors adjust to what they need now or if they forecast what they think leverage costs will be in 3-, 6-, or 9- months down the road.

As I noted many times now, distributions are slated to be cut 15-20% on average. We could see some funds that were already under-earning and/or have unfavorable leverage terms could cut even more.

Check out DWS Muni Income (KTF) which has now cut three times for a total reduction of -16.7%.

distributions

CEFConnect

Distributions are the primary reason investors buy munis, so while many investors can ignore the NAV declines as temporary but cannot take the NAV declines and distribution cuts.

Our strategy would be to find those funds that have decent UNII and UNII trends, have strong yields, favorable call schedules, and recently cut large enough to sustain them enough to not have to cut again. Ideally, the market would sell off those funds that cut giving us a nice entry point as well.

How To Think About Municipal Bond CEFs

Most CEF investors are retail investors and they can be too focused on short-termism, or the performance over short periods of time. Long-term investing seems to be going extinct in most areas of the market.

Commish JW had a great quote not long ago:

Each time he buys a ("muni") bond it is like adding a brick to the wall. I never look at it again or its price. People can't do that with CEFs because they look at the price everyday.

And here is another more specifically about muni CEFs:

If you buy muni CEFs, dividend auto-reinvest (for those that don't rely on the income right now) if you can "dollar cost averaging" or, alternatively, immediately reinvest distributions in the "best/cheapest" muni CEF you own. Build shares. Interest on interest is a powerful force over time."

Most municipal bond investors are buying based on the income flow. In late 2018, we saw a similar macro setup and decline in NAVs as interest rates rose. Many distributions were also cut then similar to what we expect in 2022.

As I discussed not long ago investors need to realize that declines in muni CEF NAVs are NOT a result of higher credit risk and a return OF your capital, but higher interest rates and the return ON your capital.

In other words, investors need to realize that these are LONG-TERM investments that will experience a roller-coaster in values. However, if we can navigate the distribution cuts, we can focus and keep the power of the income streams rolling.

Distribution reinvestment in these times can create some significant improvements in income streams that can help offset any potential cuts that materialize. Just a year ago, there were virtually no funds that paid over 5% and very few that paid more than 4.5%. Today, there are 63 funds that pay more than 5.0% and even 5 funds paying greater than 6.0% and three paying more than 7.0% (with some of that taxable and ROC).

The declines in the NAV are a result of interest rates rising and not defaults or a higher credit risk environment that may lead to defaults down the road. At some point, rates will come down and these values will bounce back up. In the meantime, those investors who can stomach seeing their investments drop another few months before recovering should stay in them and continue to collect their cash.

Too many investors focus on these investments with too short a time frame. If they were meant to be a short-term investment then they would be issued with maturities of less than 20 or 30 years. But they rarely are...

What Should Investors Do Today With Their Muni Portfolios?

Portfolios loaded with muni CEFs are likely down about 15% since the start of the year or down about 3x of what the S&P 500 has declined. This is counterintuitive as lower beta, lower risk assets should fall less than what higher risk assets fall.

The problem is that the driver of that decline is a credit or risk-based variable. Interest rates are rising for the wrong reasons. Typically, in expansionary environments, rates rise as growth accelerates. Today we have growth decelerating (significantly as the Atlanta Fed's GDPNow estimate for the first quarter is a mere 0.7%).

In more normal times with that kind of deceleration rates would be coming down if not for this current inflationary problem. Eventually, supply chains will get fixed and demand will slow allowing prices to drop or at least substantially slow their increase.

From a portfolio perspective, we are contrarian investors, meaning we would want to allocate to sectors that are down and out and harvest our gains from sectors that are in favor and richly priced. Most of the sectors in the bond world are mean-reverting, meaning that there is a fair value line that you can trade off of. This is a longer cycle 'trade' meaning that we are rotating every 12-36 months, not every hour.

Back in September of last year, we sold a significant amount of muni CEFs and moved them into open-end funds like NHMAX, OPTAX, GSMTX, MMHIX, among others. This is a counter-cyclical approach to valuations despite what I noted above (that munis are meant to be long-term investments focused on the income). For me, I am not in retirement mode and do NOT live off the income.

But you will notice I didn't go to cash. I went into other municipal assets. The end result really is that I removed the discount risk from the picture but kept the overarching exposure in place - muni bonds. I also reduced my leverage risk a bit though some of those open-ends do carry leverage like a muni CEF.

So what should investors do with their muni CEFs held throughout?

Unfortunately, there is no clear -cut answer. If you can stomach the volatility and NAV declines (and likely discount widening) then I would just hold and focus on tax swaps (booking the loss and rotating into a different muni CEF) to offset future capital gains.

Now is not the time to be selling and moving into dry powder. You have to ask yourself how you would feel if you sold today and over the next month rates declined and muni CEF NAVs recovered by 5%, or 10% or more. That may be harder to stomach than another few percentage points of decline in market value due to rates rising.

Is it a time to buy?

As I discussed earlier, I have been extremely surprised how discounts have responded to this extremely aggressive rate-rising environment. I'm very surprised we are not back to that 99th percentile in discounts today in muni CEFs. Even if we were, I don't know how aggressive I would be buying today either as I think rates are still moving higher and could be for the majority of the rest of this year.

It is possible we still get there as we progress through the summer and investors get fed up (pun intended) with their muni CEF losses and abandon the space. I do think that all the talk of recession on the financial media channels are helping to create some demand for muni and specifically muni CEFs. I also think that the valuations of last year - given how rich they were - is also helping to create a sense of value or 'cheapness' in the muni CEF market. After all, it has been nearly four years since muni CEFs have been this cheap.

Right now, the only buying I have been doing have been tax swaps and some distribution shoring up. That means, moving from some funds that have lower coverage ratios and UNIIs and into one's on our Muni Core Portfolio tab that are "buy-rated."

However, some investors may want to start accumulating some new positions (net aggregate increase in exposure) to their muni CEF portfolios. That could be by rotating back from muni mutual funds or other lower risk assets and cash substitutes or cash itself. Or it can be from fresh new capital from a one-off event or cash flow.

I would suggest some sort of dollar-cost averaging program whereby you set a target allocation for muni CEFs in your portfolio and you simply buy a piece of that percentage each week, every other week, or each month over a target duration (I would suggest 9 months).

So if you eventually want to have a 10% weight to muni CEFs I would be buying about 1.1% per month for the next nine months all the while making tax loss swaps and other distribution/valuation swaps along the way.

Top Picks Today For Distribution Stability

Obviously, any fund that has cut big and is from a sponsor that tends to cut once and be done will be the best place to be for distribution stability. As we noted a few times in the past few months, as these distribution cuts roll through it will likely open up opportunities. This is especially the case if they cut by more than -15%. In some cases, we may see the new yield be close to what it was before the cut if investors sell off the shares hard. That would be a great opportunity if it occurs.

Be patient on these. It can take up to 3 months for the discount to widen out after a sizable cut.

The criteria I am using below are a combination of fundamental and valuation factors. We want distribution stability, strong yields, but also a good deal at the moment. It doesn't do any good if we really need to pay up in order to get a higher yield and/or distribution stability.

(1) Mainstay MacKay Defined Term Muni Opp (MMD), yield 5.72%, discount -5.6%.

The distribution has been announced for the next three months. Coverage is at 100% and the fund has a large UNII bucket. The -5.6% discount is about 2.5 standard deviations below the five-year average. Hard to beat that in this current environment.

(2) Nuveen AMT-Free Muni Credit (NEA), yield 4.97%, discount -8.8%

NEA just cut their distribution by 5% (and NVG which also just cut). That bumps the coverage back up to 102.8% and UNII remains positive at +2c. Nuveen appears to be a bit proactive here getting the coverage back above 100% but not making a larger cut against future increases in leverage costs. That's a negative here but future cuts should be in the same ballpark as this one was, maybe slightly more.

(3) BNY Mellon Strategic Muni (LEO), yield 5.12%, discount -8.6%

LEO cut back in October from $0.035 to $0.03 (-14.3%) which could be enough to keep it above water for some time. The latest coverage ratio is 109% and UNII is +2.2c. That doesn't make it immune from future cuts but it will likely take time to burn off that coverage and UNII. The discount widened back out on Monday to the wides of the year.

Sister funds DMF and DSM also cut by 11%+ just last week. Watch for those funds to sell off as they haven't even reacted to the reductions yet.

(4) Blackrock MuniVest (MVF), yield 5.16%, discount -10.5%

The fund has 99.7% coverage and a small amount of UNII but has been able to navigate the environment very well. UNII has been relatively stable so any cut that does come will likely be a small one. The discount is very wide here and a compelling buy.

Alternative: Blackrock MuniYield Quality III (MYI), yield 5.16%, discount -10.7%, has higher UNII at +5.8c but lower coverage at 97.6%. MYI and MVF are very similar so you may want to spread your bets around.

(5) Eaton Vance Municipal (EVN), yield 5.05%, discount -9.04%

This is a top-notch fund that hasn't had to cut in the last several years. Coverage is 99.8% and the fund still has 6c of UNII stored away. It is also a bit higher quality compared to the Nuveen and Mainstay funds. The current discount is now over 1.5 standard deviations below the five-year median average of -6.2%.

(6) Invesco PA Value Muni (VPV), yield 5.02%, discount -13.3%

I didn't want to include a state fund on this list because I think Nationals are a better value here. However, this fund just cut by 7% and the discount is extremely wide at -13.3% along with a 5%+ tax-free yield. And if you happen to live in Pennsylvania, it is tax free on the state level as well.

(7) PIMCO Municipal Income (PMF), yield 5.7%, premium +0.2%

I found it hard to recommend a fund trading at a premium- even if it is ever so slight a premium - when so many funds are carrying double-digit discounts. However, this fund has a yield of 5.7% giving you some cushion should PIMCO have to cut this divy. Coverage though is 111.1% and UNII is +10c. It's rare to have to cut with those kind of numbers. The small premium is actually the cheapest this fund has traded in nearly 4 years and is almost 2 standard deviations below their 5-year average valuation.

ON WATCH:

(1) BNY Mellon Muni Bond Infra (DMB), yield 5.36%, discount -9.7%

They stopped reporting call schedules about 18 months ago but the last time they did it showed significant calls this year and next. That is because the fund was launched in 2013 and most positions have 9-10 years before they become callable. They haven't cut the distribution in over five years. Hard to beat that kind of consistency. I just don't like how they stopped reporting them - likely because I'm a cynic and they are bad. Mind you that the yield is above average and can absorb a cut and still be competitive. This is NOT a reason to run out and sell.

fact sheet

BNY Mellon

(2) Nuveen Quality Muni Inc (NAD), yield 5.53%, discount -9.6%

I always get suspicious when your sister funds cut and you don't. We saw NVG, NEA, and NZF cut but for some reason Nuveen didn't feel the need to apply the same cleaver to NAD even though coverage is just 94.5% and UNII is down to 4c. Perhaps they want to run that UNII down further, closer to zero before cutting just to be sure.

Concluding Thoughts

NAVs remain in free fall and we have just started to see distribution cuts filter through the municipal sector. As the Fed raises rates and very short term yields (<1 year) move higher towards where the 2-year yield is today, we will see many more funds cut their distributions.

There is a lag effect here and it will take time for all of this to happen. As the Fed raises rates over the next two months, the short end (1m-, 3m-) will move up flattening the totality of the curve. That is what is important for muni CEF investors and what will really drive muni distribution cuts.

curve

Daily Shot

For now, I remain cautious and largely in a waiting pattern to look for some rate stabilization and money flow reversal. We could be on the cusp of that given this morning's inflation report but we will see.

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This article was written by

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Targeting 8+% Income Stream using CEFs, ETFs, Munis, Preferreds and REITs
Yield Hunting: Alternative Income Opportunities is a premium service dedicated to income investors who are searching for yield without the high risk of the equity market. We are one of the top experts in closed-end funds ("CEFs") in the country having spoken at many national conferences on how to incorporate CEFs into client portfolios. We manage four portfolios that investors can follow:



- YH Core Income Portfolio: yield ~8%
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Plus: Muni CEF Shopping List.


Our team includes:

1) Alpha Gen Capital - I am a former financial advisor and investor. Not someone from another career doing this on the side. My analysis is meant to provide safe and actionable insight without the fluff or risky ideas of most other letters. My goal is to provide a relatively safer income stream with CEFs and mutual funds. We also help investors learn about investing and how to properly construct a portfolio.

2) George Spritzer - Another career financial guru who runs a registered investment advisor with a specialization in closed-end funds for individuals. George uses the following investment strategies:1) Opportunistic Closed-end fund investing: Buy CEFs at larger than normal discounts to NAV and sell them when the discounts narrow. 2) Exploit special situations: tender offers, fund terminations, fund activism, rights offerings etc.

3) Landlord Investor- spent his career as a management consultant for public sector clients at a multinational consulting firm in the DC area. He has transitioned to a new career as a full time landlord. His investment portfolio is comprised of two parts -- broad-based index funds and income plays such as preferred stock, CEFs, and REITs. He also owns individual/baby bonds which he buys on margin to boost total return. Landlord is our 'individual preferred stock' expert analyst.

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Disclosure: I/we have a beneficial long position in the shares of MYI, LEO, DMB, PMF, 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.

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