This report and the data within were published to members on Jan. 8th.
Municipal bonds finally had their place in the sun in the fourth quarter after a weak first nine months of 2018. The Fed continued to raise rates in December, pushing up the 24-hour rate to 2.25-2.50%. While the Fed did note that two rate hikes were possible in 2019, recent commentary and economic data puts those into severe doubt.
We have discussed the flatness of the yield curve all year, but what we haven't discussed is just how steep the muni curve is today. The variance between the slopes of the municipal yield curve and the treasury curve is near an historical extreme.
This oddity would seem to suggest that either the Treasury curve is too flat, munis are too steep, or that something is different this time that justifies the divergence. I tend to think it's the latter, with the culprits being the different buyer bases for the two fixed-income assets and years of ultra-loose monetary policy that distorted global debt markets.
This appears to be largely due to the fear of higher rates - and muni investors getting burned earlier this year. The need for munis has largely stayed the same even with the new tax bill. However, many investors have decided to mitigate their interest rate risk by piling into the short end of the curve while shunning the long-end. This has created the steeper yield curve for municipals.
There appears to be some opportunities to owning long-dated munis. However, be careful as the 10-year yield appears to have made an interim bottom and is now climbing again. Prices so far in 2019 have been strong thanks to a combination of continued flight to safety but also because of a crazy dynamic - more buyers than sellers.
Still, it does look like the Fed is going to pause on its rate hikes and maybe do one or two next year - at most.
Some Additional Reading:
Municipal Closed-End Funds
Dreyfus Municipal Bond Infrastructure (DMB)
The company recently posted the November fact sheet, which showed not much difference from October. If you recall, we highlighted that the portfolio managers made significant changes in October (compared to September) implying quite a bit of trading:
AMT holdings dropped from 15% to 5%
Pre-refunded issues increased from 1% to 8.5% of portfolio
Bonds maturing in five years or less basically eliminated
The result of all these swaps is a changed call schedule:
10% callable in 2018 (up from zero)
now 0% callable in 2019 (down from 9%)
3% callable in 2020 (down from 5%)
The fund continues to trade well below NAV at a 10.3% discount. It has shown some closure in the last couple of weeks, although others have rallied more sharply. Conversely, it also hasn't realized as large a widening effect in the fourth quarter like other funds have.
The yield continues to be right around 5.25%. The data is now getting a bit stale with financials only through August available (new financials should be out around May 1). That data shows coverage at 103.2% with UNII of 6.4 cents.
Action: We would continue to hold and/or build a position in DMB opportunistically as the Google Sheet dictates.
In our monthly model, we have observed the Putnam funds near the top of the list for most undervalued (i.e. discount too wide for the fundamentals) since the summer. This was a bit unusual as funds will mean revert fairly quickly or their financials will deteriorate, justifying the wider discount and thus moving them down the list. Then, in mid-November, when PMO and PMM announced they were raising the distributions by 25% and 10.7%, respectively, the model was screaming buy! We chose not to recommend the funds because the latest financials we had at the time (April 30) were not very encouraging, even though a dividend increase is normally a sure sign of financial improvement. We decided to wait a month for the October results to be released in December.
As feared, it appears the financials for PMO and PMM are catching up to the market. The recent massive distribution increases don't appear to be sustainable. The low coverage for both funds dropped even further and UNII eroded. And, these figures were for the period before the higher payouts had even kicked in! We would avoid these funds.
Recall that we reviewed MAV's financials as it reports almost exactly one month prior to that of MHI. MAV's financials showed some material deterioration, and we then predicted MHI would show similar deterioration but that the fund's share price was unlikely to react negatively. At year end, the MHI report was released, and as expected, it showed substantial deterioration - more so than we thought would appear.
One of the problems of these funds is that they show calls for the next five years (like PIMCO) instead of showing the individual years.
As of 4/30/18, MHI had coverage of 117% and UNII of 15.5 cents. Following the recent release, coverage had fallen to 91%, and UNII fell to just 12.7 cents. The distribution is likely to be trimmed if they are not able to turn this around in the near term. This is a rare fund in that the last two distribution changes over the prior three years have been to the upside.
The fund has performed well in 2019 with a 3.32% share price TR over the last week. With the fund trading near its 52-week average, we think the fund is not incorporating a cut to the distribution. With the recent move higher, it may be time to start trimming back. I do like the rising NAV trend recently, but that could be short-lived if rates move back higher.
Expensive! Expensive! Expensive! These funds continue to climb higher building on their premiums with no end in sight. The recent moves in price appear to be aided by a turn up in the NAVs which have shown some strong positive movements in the last few weeks.
PML is now trading above a 16% premium, right on their 52-week highs and well above the 10% average and 3.5% lows. The NAV is finally moving higher, but the price is moving at a far stronger magnitude.
We wrote about the potential for PIMCO muni distribution cuts more extensively in "PIMCO Muni Fund Distribution Cuts Coming?"
We wrote of it back in July:
Three funds are in the danger zone for a potential distribution cut
I would throw Pimco California Municipal Income Fund II (NYSE:PCK) and PIMCO California Municipal Income Fund III (NYSE:PZC) into that mix as well. We could see widespread cuts in their muni funds as we did last year.
From a fundamental point of view, the only PIMCO muni fund that looks remotely attractive is PMF with 94% coverage and 3 cents of UNII. The rest of the fund complex is either far too expensive from a valuation standpoint, or the fundamentals are just too shoddy to allocate capital.
BlackRock (NYSE:BLK) has about 28 funds in their lineup dedicated to the national municipal bond space. The average coverage ratio (through November) is now 99.3%. One of the issues we have had with the fund complex, in general, is the large amount of calls that most of their funds faced in 2018. The question is how much are they still facing and what's the probability of that occurring as we progress into the back half of 2019? Many BlackRock funds sport the largest three-year distribution changes in the entire muni CEF space.
We track all funds across sponsors, including coverage ratio, UNII, and changes in both of those figures to track trends. For the BlackRock funds, we can group them into the following buckets:
Funds with small amount of UNII but likely to be okay near-term: MUA
Let's look through the seven "safe" funds plus BTA, which recently cut by 7.3%.
Call Schedule (next two years):
BTA: ~24% MUI: ~11% MUH: ~22% MQY: ~10% MQT: ~12% BLE: ~27% BKN: ~12% BAF: ~15%
That weeds out MUI, MQY, MQT, and BKN.
BlackRock Muni Intermediate Duration (MUI): Coverage at 103% with UNII of 3.3 cents shows solid fundamentals. UNII has been rising for most of the year, though coverage has been slipping in the last several months. Still, you have plenty of cushion before the next cut will need to be executed. Compared to other muni CEFs, this discount, while large at 13.7%, is not far from the one-year average of 13%. The yield also is low at 4.13%.
BlackRock MuniYield Quality (MQY): Very similar to MUI with coverage of 102% and UNII growing and now over 3 cents. However, this fund has more discount room to tighten (12.2% vs. 10%) and a much more attractive yield at 5.03%.
BlackRock MuniYield II (MQT): Same story here. Coverage at 102% and UNII of 2.1 cents and growing strongly. Yield is OK at 4.91%, and the discount at 12.3% gives you just over 1% of closure potential. Not great but a place to allocate capital if you need more ideas.
BlackRock Investment Quality Muni (BKN): More of the same with coverage at 101% and UNII at 6.7 cents and growing. The discount at 11.3% compares to a one-year average of 10.4%. The yield is also more compelling 5.04%.
BlackRock Muni Income Investment Quality (BAF): This 5.34% yielder cut back in August and is now close to earning the distribution. UNII is over 7 cents, and the discount looks appealing just over 10% compared to a one-year average of 9%.
BlackRock Long-Term Muni (BTA): Coverage is over 100%, and UNII should stabilize at or near the current 3.5 cents. The yield is much more attractive at 5.52% with the discount showing about 1% of potential discount closure. While the call schedule is rough, they just cut the distribution so conceivably they've adjusted the payout based on those calls they see occurring over the next 12 months-plus.
There is definitely some opportunity here on the BlackRocks. It's possible that the above funds' discount tightens beyond the 52-week average. "Cousin funds" MVT, MFL, and MUA have all already tightened beyond their 52-week average.
The above funds are all very similar - differing flavors of the same exposures, yields, discounts, and call schedules. They are more suited for a buy-and-hold mentality, but that does not mean set it and forget it. Each month, you should be cognizant of the changes in the coverage ratios and UNIIs to stay ahead of the market if a cut is pending.
From a fundamental standpoint, the Nuveen funds look less appealing than the BlackRock funds. Most of their national munis have a negative UNII balance though the average coverage ratio is 104%. For Nuveen, they tend to cut when coverage gets to the low 90% area and UNII negative. It will not take much to see coverages wane given some of the call schedules.
One fund we would spotlight, and may be one of the better longer-term opportunities, is Nuveen Municipal High Income Opp (NMZ). This fund has coverage near 106% and UNII of 1.7 cents and rising. The yield is highly compelling at 5.67% with a discount of 8.6%. The wide discount is due to the fund cutting twice in the last year (total -13%), but the payout is still very attractive despite those cuts, and the fund looks safe from further cuts for at least the next 3-6 months.
Despite the name, over 50% of the fund is investment grade with another 25% in non-investment grade rated issues, and 25% unrated. More compelling characteristics:
Average coupon is 5.58%
Average bond price well below par: $99.3
Call schedule shows:
Over the past 10 years, the fund ranks No. 1 in the high-yield category (only 10 funds).
The current discount of 8.6% is well below the 52-week average of 4.63%, indicating almost 4 points of potential closure. This fund traded very close to par back in July.
NMZ's average bond price under par ($99.30 excluding zeroes) is encouraging. That suggests that perhaps half the portfolio would not be hurt by a par-call (or a call is unlikely).
Invesco PA Value Muni (VPV): This is a fund that raised their distribution nearly a year ago. With a highly compelling yield (5.81%) for the credit quality, the fund's discount has been closing. Compared to most other funds in the muni sector, this fund is trading near that 52-week high. But the coverage ratio is slipping and fell to 90.8% in October with UNII of 10.1 cents. That UNII cushion should help protect it. In addition, the call schedule is very favorable. For now, I'm holding this position.
Delaware Investments National Muni (VFL): Another fund that meets all our criteria but that has low liquidity (only 8,000 shares trade on average per day). Coverage is 100%, UNII a positive 15.9 cents, and the yield, just under 4.9%. The discount is close to the 52-week average, but it could still close another 2 points.
Invesco Muni Income Opps (OIA): A fund that cut the distribution back in September and is now earning the distribution with a slight UNII cushion. The fund is more junky than VPV. The discount is tightening fast with the discount down below 2% now, from over 5% not long ago. This one appears headed towards par.
The "January effect" appears to be in full throttle after the first week of the month. Our analysis has concluded that, from a fundamental perspective, muni CEFs aren't very attractive long term. Near term, we are seeing an outstripping of supply by increased demand. That demand is likely being driven by fear returning to investor mindsets.
In a gradually rising market, investors can succumb to some false confidence thereby shunning areas of the market like munis. During the first nine months of 2018, this is what happened. Munis were down, in some cases significantly, as interest rates rose and the markets zoomed to new highs. Then, the bottom fell out, and munis became popular again as a flight to safety. The question today is, just how long will munis be popular if the market continues to recover and eventually hits new highs?
Holding a small allocation to munis or other "natural hedges" that act as ballast is important, especially during the late cycle. We ran through a quick exercise detailing the current environment.
When are muni CEFs the most desirable?
When the earnings yield minus the leverage cost is widest. In other words, when the curve is steep. Not ideal.
When portfolio bonds losing call protection no longer will be called away. Not ideal.
When rates are falling and the NAVs are benefiting. Ideal today (but for how long?).
When UNII balances are large providing distribution stability. Not ideal.
When discounts are at record levels. Ideal today (but closing).
The data suggests that despite the rally we have been seeing, unless we see renewed market instability, muni CEFs are not a place to jump into with your entire portfolio. The two positives we see: Falling yields and wide discounts lend to a different strategy.
Our main strategy has been to buy funds that have distribution stability. Funds that are unlikely to surprise us with a 10-20%-plus distribution cut sending the share price reeling and costing us several years' worth of distributions overnight. While avoiding these is still important, we do think the main opportunity today exists from a mean reversion aspect. That is, discounts closing toward their one-year and three-year discount averages.
Recall that just 18 months ago, the average muni CEF was at a premium. If the Fed does indeed indicate that they are pausing, we could see further renewed interest in muni CEFs outside of the flight to safety trade.
What funds would we look at?
Nuveen Muni High Income Opp (NMZ): This 5.67% yielding fund cut twice in the last year but is now earning the distribution with a small positive UNII balance. The discount is 8.6% while the one-year average is 4.63%, and the 3-year average is 0.44%.
Delaware Invest CO Muni Income (VCF): The only state specific CO muni fund now trades at an 8.3% discount compared to a 3.3% average - and closing fast. The yield is a little lower at 4.51%, but the credit quality is very high. The distribution was cut in September, and the fund now earns the distribution (100% coverage) with a 12.7 cent UNII bucket.
Eaton Vance National Muni Opps (EOT): While not a fan of EV muni funds in general, this one is trading near a 7.3% discount, while the one-year average is less than 2%, and the three-year average below 1%. The distribution is unchanged since 2016, so that's not the driver of the wider discount. This one looks like it could trade another 3-5 points tighter.
BlackRock MuniYield Invest (MYF): The fund trades at a 7.7% discount compared to a one-year average of 2.6% and a three-year average premium of 1.5%. The fund did cut the distribution by 10.7% but is now outearning that distribution (obviously positioning for more calls) at 100.3%. UNII is slightly positive. Yield is extremely high at 5.76%, so you get paid while you wait for the discount to close. We think there are about 4-6 points of potential capital gains here.
BlackRock Muni Income (BBF): The fund trades near a 10% discount but has averaged 5.5% over the last year and was at a premium back in August. The fund cut the distribution by 9% in August and, today, has a coverage ratio of 100.8% and UNII that has moved back to zero after being as much as 2.2 cents negative.