Discounts widened across the board but were focused much more heavily on the municipal and preferreds sectors. Overall, taxable CEFs saw discounts widen by nearly 30 bps. Doesn't sound like much but it's a lot in a week when you look across some 170 funds. Munis, however, widened by 76 bps which is a tremendous amount for five trading days. Clearly investors are worried about higher interest rates.
Tax-free national munis were down 1.85% on price for the week but NAVs were down less than 1.1%. Despite the drop, tax-free munis are up 1.1% in the last month with the NAV up 0.8%. The sector discount of -4.1% is right around the 50th percentile of observations for the last 7 years.
Rates are rising quickly so investors are panicking. It is my thought that rates will not be allowed to rise much more than 1.6% or 1.7%. As we noted above, rates are rising for "good reasons" but despite the reasoning be good doesn't change the typical relationship between cash flows and the discount rate used to value them.
The most common question I got this week is if I should sell my muni and preferred (longer duration or more interest rate sensitive assets)? This is a typical reaction. But being a contrarian investor and counter-cyclical allocator requires you to do the opposite of what the market's knee-jerk reactionaries are doing.
Therefor, I would want to ADD duration at some point should rates rise another 30-40 bps from here. Remember, all else being equal, a steepening yield curve where longer-maturity rates are rising and short-term rates are held steady (or even fall as we saw this week) is bullish for muni CEF distributions but bearish for NAV values. In other words, the distribution becomes healthier while your principal falls. This is because the spread you earn between the cost of the leverage (short-term rates) and the coupon earned on the underlying investments increases, boosting the earnings power of the fund. For those that are primarily concerned with the distributions, then this isn't a large concern.
Of course, this means you have to watch very closely maturity and call schedules in funds as anything that is callable or matures will be replaced with much lower yielding coupons. Rates on the long-end are still well below where they were even 18 months ago.
So the question remains, what to do?
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