The Best Muni CEF Is The One That Just Raised Its Distribution

Summary

Muni funds have stabilized as interest rates have trickled a bit lower in recent weeks.

Even if rates rise further, the new coupon bonds replacing called issues will start to help offset the rising leverage costs.

Our model has identified four top candidates and four other candidates that are solid tax equivalent yields and have safe distributions.

Munis continue to find some footing as interest rates have stabilized - and even dropped on the long end a bit. We watch money flows fairly closely and capital is being poured back into bond funds in general, and especially into munis. It was recently reported that the iShares National Muni Bond ETF (MUB) raked in significant amounts of new cash. Money flows are important drivers into the pricing of munis bonds.

The difficulties with a few problem child states are well known and a few city-specific issues that have gone bankrupt garner a significant amount of attention. However, 45 states currently have AA- or AAA-rated debt according to Moody's.

 

(Source: Schwab)

In a recent report on owning bonds in a rising rate environment, we noted that there are two kinds of bond investments, interest rate sensitive and credit sensitive:

Interest rate (duration) sensitive:

  • Higher duration (more sensitivity to rising rates) but less chance of default (loss of principal).
  • Lower yielding, less upside and total return.
  • Downside protection in a recessionary environment (will still fall but much less)
  • Example: Treasuries, municipal, agency MBS

Credit sensitive:

  • Lower duration. Most high yield debt is issued between 5 and 10 years.
  • Higher yielding, more upside and total return
  • Risk of default and loss of principal (high yield default rate topped at 12% in 2009).
  • Example: Corporates, high yield (junk), floating rate

Muni CEFs allow individual investors to invest in a diversified pool of tax-free bonds in underlying sectors where they might otherwise not want to own individual issues directly. The main reason being that muni CEFs are professionally managed and monitored in a diversified fashion.

Most investors today are significantly overweight credit with little in the way of exposure to treasuries or other "near-risk free" sectors like munis. Given where we are in the business cycle, adding downside protection bond exposure makes sense.

Investing in the Muni Space

We primarily use the closed-end fund structure to gain access to the municipal space. Munis are plain-vanilla so making comparisons between funds is straightforward. We can also use our regression modeling which has proven to be a great predictor of muni CEF discounts based on just a handful of factors.

We have found that a fund's current premium/discount is dependent on the values of a relatively small number of measurable factors, only one of which is the fund's yield. These independent variables largely explain why all the national levered funds sell at their given premium/discounts. We re-run the model every two weeks as the market constantly revalues the funds. Even though each fund operates independently, its value is influenced by the others, as these are all alternatives that an investor has to choose from.

The model allows us to derive a 'warranted' discount (or premium) to NAV. Essentially, we want to find funds that the model identifies as undervalued, which then becomes the starting point for doing fundamental analysis on the sustainability of the distribution. It also allows us to identify the most over-valued funds in case our members happen to own one.

In a typical run, we see the majority of funds priced within 1 percentage point of what the model would predict. But inevitably there are a handful of outliers which are undervalued or overvalued by as much as 4 or more points of discount.

 

(Source: Output from our model)

Muni bonds have actually been performing well. Demand is solid, supply is light. Prices are pretty firm. However, muni CEFs have been pressured. Short-term borrowing rates are going up but long-term rates aren't (The yield curve is flattening.) That means that these funds are making less of a spread when they borrow short and invest long. It also means that high coupon bonds in the portfolio are still being called. That combination puts pressure on the dividend. When dividends get cut, people sell the fund and the price falls. Double hit to the investor. And the share price doesn't rebound very fast. Avoiding these blowups is paramount. Strong fundamental analysis of the key variables that can predict a cut is a primary focus.

Closed-End Fund Analysis

We recently ran some general analysis on muni closed-end funds. Just 36 funds out of 152 national and state-specific funds have positive total return on NAV since the start of the year. Using end of week data from June 15th, we created a screen of high quality funds. The funds were required to meet each of these criteria:

  1. Positive total return performance YTD (on NAV)
  2. UNII equal to a minimum of one half of one month's distribution
  3. Coverage ratio above 95%

The exercise was done to see if any funds could meet these initial criteria. Of the 152 funds, only 17 made it through our screen. 5 of them were short target term trusts.

The top fund was Mainstay DefinedTerm Muni Opp (MMD), which is up 2.6% on NAV YTD, with UNII of nearly +6 cents, and coverage at 95%. Coverage and UNII have been slipping since the start of the year but ever so slowly and a distribution is probably coming at some point in the near future. Monitoring these funds to avoid distribution cuts is the core of our marketplace service.

Pioneer Municipal High Income Trust (MHI)

One of our top selections in the muni CEF space is MHI which trades at a -9.4% discount to NAV and distributes a 5.56% income stream. This monthly-pay CEF had dropped its distribution four times between the Taper Tantrum of mid-2013 and the start of 2017. However, since then, it has been a rare distribution increaser, raising the payout twice with the most recent being in November of last year.

The shares hit their nadir in discount in March at -11.4%. Since then the discount has been shrinking. Our model predicts the warranted discount to be -6.4%, so we still see an additional ~3 points of discount closure to materialize at the current distribution level.

YTD, the NAV is up fractionally, approximately 10 bps, but price is still down -1.8%. However, in the last three months, price has risen 2.1% compared to the NAV rising 1.60%. Perhaps the worst is over for the muni funds?

 

(Source: CEFdata.com)

MHI Fundamentals

The fund is classified by CEFConnect as a "high yield" muni strategy. In the most recent semi-annual report, the credit quality breakdown was 59% investment grade, 19% non-investment grade and 22% unrated, though we typically lump unrated with non-investment grade bonds.

 

(Source: Fact Sheet)

The fund's expense ratio is 1.00% which is on the lower side for muni CEFs. Total net assets under management is approximately $386m.

The data on MHI is now quite stale with the most recent financials coming out as of October 31, 2017. At that time, the fund earned nearly 6 cents per share while paying out 5 cents per share per month. That equates to 120% distribution coverage with UNII of 17.6 cents. Which brings us to...

MAV results outprove positive for MHI

The two Pioneer "high yield" muni funds, MAV and MHI, have been strong performers lately. The key differential between the two is that MAV's fiscal year ends one month prior to MHI. Given the portfolios are very similar, we can predict the results of MHI's annual report by using MAV's. MAV released its N-CSR (annual report on CEFs) on May 30th, so we would expect to see MHI's at the end of this month.

The MAV report was very strong with net investment income per share of $0.0505 and strong gains on its assets supporting the NAV. Most importantly, undistributed net investment income (UNII) rose to $2.936 million, up from $2.395 million the fiscal year before. On a per share basis, UNII rose to 12.3 cents from 10 cents.

 

(Source: N-CSR)

While coverage for MAV is below 100%, the UNII balance is highly supportive of the current distribution. Additionally, if management was at all concerned about the sustainability of the payout, they would not have raised it back in November of last year.

Because the funds are so similar, pay the same dividend, raised the dividend by the same amount at the same time, etc. we are projecting MHI's financials will be similar to MAV's. MAV is currently selling at a -6.2% discount while MHI is at -9.4%. Not surprisingly, given the similarity of the funds, our regression model says MAV is close to fair value while MHI is quite undervalued.

Conclusion

For those looking for muni exposure with some possible upside from mean reversion on the discount, MHI can offer up a solid 9.22% tax-equivalent yield in a much safer fashion than you would find in the taxable or equity space for similar yielding stuff.

We may have finally turned a corner on munis but that all goes out the window if rates jump back higher and continue to increase. That said, if rates were to rise, the economic viability of muni refundings and calls declines. We have already seen a few issuers cancel planned refundings because of higher rates.

Most long munis are issued with 10 years of call protection. If a fund owned bonds that were issued in 2008 or earlier, by 2018 these were susceptible to being called if the issuer could re-finance. The drop in muni rates has been so severe that most high coupon bonds that could have been called have been called. And that income can't be replaced dollar-for-dollar. Going forward, as each year passes, the next tranche of bonds in the fund becomes exposed (in 2019, any bonds issued in 2009 become callable) and so on. We are still a few years away from the point where the weighted average coupon in muni CEF portfolios will have declined enough that redemptions are not as damaging.

The biggest issue facing muni CEFs today is the rising expense of leverage financing decreasing the spread between earnings and cost. Leverage costs will continue to rise as the Fed raises the Fed Funds rate with another two hikes planned for this year.

Our service is focused on building safe distributions and income streams. We typically sell out of funds as soon as they announce an unexpected cut to the distribution. This is because most CEF investors tend to not realize their income has been cut until they get the next payment. So investors who are on top of the cuts have at least a few days before the price reacts.

Right now, we have four top national funds that we think are well positioned for the current environment and safe from a distribution cut. In addition, we are recommending four other funds including two state-specific funds and a muni CEF with no leverage.

If you are a buyer of municipals, then give our service a try. We make a substantial investment in CEF data, monitor the funds daily, have proprietary analytical tools, and can help you navigate the dicey environment muni CEFs are in right now. Individual investors need someone in their corner to help select among the dozens of funds. Or sell you out of a loser. And since muni CEFs have historically "always" had a great bounce back year after a negative one, the timing is good to join.