Is There Value In Municipal Closed End Funds?

In a recent article here on LearnBonds, I discussed why investors might want to consider municipal bonds. The short story on municipals is that they bring tax advantage, diversity, and stability to portfolios that may be overloaded with dividend equity, corporates, or other income producing securities.

In general, tax-free munis will carry lower coupons and yields relative to corporates with similar maturity ranges and credit quality. But if you are in the 28% tax bracket, it may make more sense to purchase a 4% muni issue than a 5% corporate piece of paper, since on an after-tax basis your 5% taxable bond yields only 3.6 percent.

Though investors considering municipals may be content with yields on individual issues, the closed-end market currently offers elevated yields of as much as 7% in funds utilizing leverage and trading at a discount to net asset value. In a recent search I conducted on CEFconnect.com, I found 200 municipal closed end funds available for purchase. Here is a small cross-section of what is available:

Ticker Fund
Name
Strategy NAV Effective
Leverage
Dist.
Rate
Premium/
Discount
Market
Cap
NMA Nuveen Municipal Advantage Tax Free Income National  $14.96 36.69% 6.01% -10.56% $585M
NMZ Nuveen Muni High Inc Opp Tax Free High-Income Yield $13.30 33.48% 6.87% -0.15%  $665M
VKI Invesco Adv Muni Inc II Tax Free Income National  $12.30 41.16% 6.64% -8.13% $502M
MVF Blackrock MuniVest Tax Free Income National  $10.09 38.55% 6.97% -3.57% $623M

While the 6-7% yields may seem tempting, there are elevated, layered risks and variables associated with CEFs. First, we have the general risk of investing in bond funds – that is the risk that you are not guaranteed to recoup the capital that you invest. A bond fund’s net asset value fluctuates relative to prices of the fund’s individual holdings, which in general, move in relation to interest rates. Further, since CEFs are traded on the open market like stocks, investor sentiment tends to drive where prices sit relative to net asset value. When a sector is “hot,” premiums tend to appear – when sentiment is “cold,” discounts arise.

Closed-end funds also frequently utilize substantial leverage (borrowing) to achieve robust yields. Briefly, CEFs will borrow money to purchase extra securities for the fund. So if the fund borrows money to increase fund assets by 40%, pays 2% to borrow those funds, but is able to get 4-5% yields on the borrowed money, it is able to increase distributions to investors relative to performance without leverage. Of course there is potential downside to leverage. If bond prices tank with the fund levered, net asset value (and likely market price) could diminish more rapidly than it might have if it were not levered.

Last year, when the Fed announced the taper, most bond-related CEFs took it on the chin. Many funds which had been trading at premiums sunk to double-digit discounts in short order. The below chart for NQM, Nuveen Investment Quality Municipal was fairly typical of what happened.

Slide1

 

Late last year, as investors likely sold these funds for tax-loss selling purposes, they represented substantial value in my view. Today, however, as rates have backed off a bit, NAVs and market prices have risen, and as discounts have variably narrowed, the value seems to have narrowed as well.

Still, for investors not satisfied with coupons and yields found on individual issues, the convenience and premium distributions found in CEFs may be a reasonable solution. This solution does come at a price however. It is not uncommon to see expense ratios pushing up against the 200 basis point (2%) threshold – typically in funds with lower assets and higher leverage. So expense is yet another consideration for prospective investors.

Conclusion
Municipal closed-end funds represent a rather complex alternative for those needing or wishing to expose themselves to the tax-free income milieu. Though the elevated yields create allure on the surface, investors would be wise to consider the multitude of variables and risks associated with bond fund investing in general, and CEFs, in specific.

About the author:

aloisiAdam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

 

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