Muni Market Update | February 2019

Buy Today For Discount Capture:

  • Blackrock MuniYield Invest (MYF)

  • Blackrock Muni Income Inv (BBF)

  • Blackrock Long-Term Muni (BTA)

Buy-And-Rent (HOLD)

  • Mainstay McKay DefTerm Muni Opps (MMD)  - HOLD

  • MFS High Income Municipal (CXE)  - HOLD

  • Dreyfus Muni Bond Infrastructure (DMB) - HOLD

  • Blackrock NY Muni Income II (BFY) - BUY

  • Nuveen High Income (NMZ)  - BUY

  • Invesco PA Value Muni (VPV) - TRIM

In the first six weeks of 2019, the muni yield curve has rallied sharply and prices have risen nicely in conjunction with the overall market rally.  Demand for the short end of the curve (less than 5 years) has push down yields on those bonds by as much as 20 bps.  Conversely, yields on the longer end have fallen just a couple of points so far this year.  The opportunity continues to be on the longer-end of the curve, all else equal as investors are clearly scared of rising rates.

Last month, we highlighted five funds that we thought you could buy for the discount capture and five funds to hold for a period of time.  Let's review those picks.  

Discount Capture:   NMZ, EOT, VCF, MYF, BBF

Buy-And-Rent:  MMD, CXE, DMB, VPV, NMZ

Our discount capture funds performed well with only one slightly underperforming the VanEck Municipal Income ETF (XMPT).  The buy and holders were about average (though they destroy it over a 3-year time frame).  The difference between the two categories is simple.  We aim to hold the discount capture funds for a relatively short amount of time (3-9 months) to capture the discounts closing, and then sell.  The "buy and hold" which we also call the 'buy and rent' funds are the best from a fundamental standpoint.  That means we believe these to be the highest yielding funds with the best call schedules, coverage/UNII/etc., and least chance of a distribution cut.  These we aim to hold unless valuation gets completely out of whack or those fundamentals change.

Nuveen Muni High Income (NMZ) was one of our top picks last month in both the buy-and-rent and the discount capture opportunities.  It ran the most rising over 6.1%.  The current discount is now just 1.60%, which is almost 3.5 points tighter than the 52-week average and only about another point off the 52-week high set in August of last year.  We continue to hold it for fundamental reasons and think it could get a bit closer to par.  Even if it doesn't will ride the rising NAV.

EV National Muni Opps (EOT) was our top convergence trade opportunity which played out perfectly.  The fund was at a 7.3% discount when recommended and today trades very close to par, a 7.6% total return.  We are not big fans of EV muni CEFs and given the run, we would take profits on this name. 

Delware Invest CO Muni (VCF) is a CO muni fund with very high quality holdings though the fund itself has lower amount of liquidity.  The yield is also a bit lower at 4.35% but the fund still trades below the 52-week average (-3.9%) and is a long way from the 52-week high (+1.7%) at the current discount of -5.5%.  Perhaps this one is still recovering/healing from the distribution cut it received back in September of last year and/or perhaps the yield is just too low to entice many out-of-state investors.  And then there's the liquidity problem with only ~10K shares traded daily.  We would avoid this one unless you're already in it given that lower liquidity or unless you live in CO.   One positive note: December quarter’s UNII balance was not only large (16.7 cents/share) but up sharply from just 3 months previous (12.7 cents). 

Blackrock MuniYield Inv (MYF) was another convergence trade that played out well.  It's V-shaped recovery is nearly complete and the fund is now trading back above its 52-week average.  Since this fund sold at a 5% premium last summer, there's a possibility of a few more points of convergence, though the easy money has now been made.  We're 50/50 on selling vs. holding.  It may be just that we take some off the table and see if we can sell at or close to par.  The fund cut in January so another cut is unlikely for the next 6 months, making it a “safer” hold from that perspective.

Blackrock Municipal Income Inv (BBF) was again, another convergence trade that worked.  It is now about a point tighter than the one-year average discount and about 6 points from the 52-week high.  The yield is competitive at 5.36% so there may be a few points left on this one as well.  They just cut the distribution last month so the risk of another cut is low.  

Buy And Rent Funds

Mainstay McKay Muni (MMD) remains our top muni holding though it now trades at a premium valuation and near the 52-week highs.  We don't typically trade this one though have been known to use as a source of cash when the fund trades at a premium and rebuying when it get below a -2.5% - -3.0% discount.  For the trades, sell and wait to rebuy.  For the investors, just hold here.

MFS High Income Muni (CXE) is the laggard of the 9 recommended (but the numbers above are incorrect as the fund returned +2.94%).  The fund is closing the discount and now sits at a -5.2% discount compared to a -7.4% 52-week average.  We are slowly moving toward the 52-week highs. The yield is very competitive at 5.48% but we feel this fund (and its sisters CMU and MFM) won’t ignite until the distributions turn back up.

Dreyfus Infrastructure Muni (DMB) is our second largest position and has finally started closing the discount after over a year of holding it. At a 7% discount, the fund is near the 52-week high and much narrower than the 52-week average of -10.8%. The yield is still "ok" at 5.00%. It may be hard for it to close more given the yield will soon sport a 4-handle but we will continue to hold long-term for the income. The call and maturity exposure for the next 3 years is about as good as it gets in the muni CEF space.

Invesco PA Value Muni (VPV was our big state-specific play from both a fundamental and technical (quant) point of view. The yield on the fund was high over 5.8% and traded at a -13%+ discount when we first mentioned it in February of 2018. In addition, the fundamentals were strong with a recent increase in the distribution, large UNII bucket, and favorable "call wall". The fund is up 9.76% total return. The one-year z-score is now +2.20 and the discount at -9.5%, close to the 52- week high of -8.9%. I am holding my position as I do think the juicy yield, decent liquidity (~57K shares per day traded) and strong fundamentals could produce a few more points of gain. Even if it doesn't, the 5.75% tax free yield isn't bad! We continue to watch UNII for signs of an imminent cut. UNII peaked last September at about 12 cents/share and has been slowly burning off at about 1 cent/month. We have observed that Invesco rarely cuts the distribution on its many muni CEFs until UNII hits zero or goes negative. Even then, they will supplement with ROC if necessary before cutting.

Overall Muni CEF Market

The CEF market has seen a significant rebound in discounts with the January effect boosting prices.  Funds are still seeing some discount compression and benefiting from this annual phenomenon but overall, it is slowing as most funds are back near their 52-week averages and many near their 52-week highs.  

The average discount today is approximately -7.1%, which is about 3 points tighter than 5 weeks ago.  Even better is the total returns with a 6.5% YTD total return on price and a 1.16% YTD total return on NAV.  The average one-year z-score today is +0.9, a shift from -0.5 last month.  

Let's go through the other funds on the Muni Core tab.

Blackrock Long-term Muni (BTA):  The fund announced a cut for January of about 7.3% in their December 3rd press release.  At the time, the fund traded very close to the same discount it does today.  The yield is still competitive despite the cut and the most recent monthly coverage numbers show an improvement to 101.9%, although UNII will take a month to stabilize. We like the fact that Blackrock cut while BTA still had 3.3 cents/share of UNII left; most of the other funds they cut were almost down to zero.  With the one-year average discount at -8.2% and BTA now 2 points tighter, this one looks tapped out from a convergence perspective.  That said, NAV is still rising nicely and it recently gave up about 2.5 points of discount in the last two weeks.  So there is precedent for it to trade tighter in the current environment.  I am holding my relatively small position.

Dreyfus Muni Bond (DMB):  See above.  

Pioneer Muni High Income (NYSE:MHI):  We issued a sell proclamation on it a couple of weeks ago.  We think we wait for the distribution cut that is likely coming soon and then consider a rebuy if the discount blows out.

Nuveen Muni High Income (NYSE:NMZ):  This was one of our top ideas last month on both a convergence basis and a buy-and-rent basis.  The current discount is just -1.6% and the move it has made recently has been tremendous.  We wouldn't be buying more here and could issue a sell rec if the trend continues. 

Invesco Muni Income Opp (OIA):  Want to talk about V-shaped recoveries? This is one that has seen it more than any other. The fund fell to a -6.2% discount in December but has since then rallied to a 4% premium. Our concern is that the fund cut back in September when the coverage was around 96% (on a rolling 3 month basis) and it is still at 96% despite the lower payout. We think you should sell out of this one.  

PIMCO Muni Income (PMF):  Another fund that has zoomed recently to a 9.4% premium, which set a 52 week high .  This fund is exhibiting stronger fundamentals with coverage growing 104.8% from 91.4% the month before and UNII adding two cents in the last month.  If I owned this, I would probably sell it on valuation concerns.  The one-year z-score is +1.70.  

PIMCO Municipal Income II (PML):  This fund is expensive!  Now at a +17% premium but still yielding 5.7%, the fund is more expensive now than it was over a year ago when the average fund traded at a premium.  The one-year z-score is now +2.30.  We took profits a few weeks ago, obviously a bit early.  UNII has stopped falling and coverage has recovered to 91%. 

MFS High Yield Muni (NYSE:CMU), MFS High Income Municipal (CXE): I’ve come to like the monthly adjustments to the distributions because it means you won't be surprised by a large distribution cut.  That said, I do think these need to see one (or likely more than one) raise to the distribution for the discount to close closer to the 52-week highs.  They are both holds here.  I wouldn't buy but I also wouldn't sell.  

Blackrock NY Muni Income II (BFY):  This one still has an opportunity as it has one of the best NAV trajectories of any muni CEF out there.  For non-NY residents, the yield is a bit low at 4.5% but the fund is nicely out-earning that. UNII is 7.7 cents and rising. Of any one fund on our Muni Core tab, this one is perhaps the most compelling currently. The portfolio is very high quality and call exposure over the next 2 years appears very manageable. For over-taxed NY residents the fund is double-tax free.

PIMCO CA Muni Income II (PCK):  This fund is trading right at par and yields just over 5%. From a valuation standpoint, the fund, especially for being a PIMCO, isn't that expensive. We would call it fairly valued here about two points higher than the one-year average but still more than 4 points below the 52-week high. UNII has toggled between zero and 1 cent for the last 12 months. This is another I would just hold but not buy here.

Invesco PA Value Muni (VPV):  see above

Convergence Opportunities

The opportunities still available in the national muni CEF space are now dwindling.  In fact, just six funds have a convergence opportunity which gets them back to the 52-week average.  A convergence opportunity is a 'total return play' whereby you not only generate the current income from the distribution but also capture some capital gains from the closing of the discount back towards the averages.  

However, is the full list of funds that have a positive convergence trade opportunity to get back to their 52-week highs (most of which occurred late last summer).  There are many funds on this list, primarily state-specific muni funds, that have large opportunities.  However, they do have very low volumes or are chronic distribution cutters. If you have a question on any, please comment below. 

5.png

Top Opportunities In The Convergence Trade Realm (Total Return)

  1. Blackrock Municipal Income Inv (BBF):  The fund is still at a -4.8% discount, and nearly 7 points from the 52 week high.  They cut in January for the second time in a year causing some selling pressure.  I think they are done cutting for now and that we are in the sweet spot (2-3 months) following the cut.  

  2. Blackrock MuniYield Inv Fund (MYF):  This one is getting close to par but i think there is a relatively easy 2-3 points left to go.  The fund also cut for the second time in January and is likely done for now.  The yield on this one is juicy at 5.40% so even if we don't see much convergence, you are getting paid nicely to wait.  

  3. Blackrock Long-Term Muni (BTA): Already mentioned above, this fund recently cut in January and pays a 5.32% yield.   With the one-year average discount at -8.2% and BTA now 2 points tighter, this one looks tapped out from a convergence perspective. That said, NAV is still rising nicely and it recently gave up about 2.5 points of discount in the last two weeks. So there is precedent for it to trade tighter in the current environment.  

Concluding Thoughts

Muni CEFs have run very nicely since our last update and are continuing to show great pricing and NAV trends.  That said, the easy money has been made if you are a short-term total return investor.  We would gradually be taking some of the money added in January (already started) and begin redeploying it into the open-end muni funds (or cash).

I do think that the muni space could see some support for the next few months.  News reports are coming out about lower than expected tax refunds mostly due to the withholding not being correct.  Once higher earners see this, they will undoubtably ask their CPAs how they can reduce their taxable income.  Munis will likely be one of those tools they could do on the investment side.  

We are cautiously optimistic here: more so on the NAV movements than on the continued convergence trade opportunities.  We have a few more points to go to get to 52-week highs but from here it could be just coupon plus or minus the NAV movement.  We continue to expect rates to inch a bit higher over the near term, though not sharply.  The 10-year is simply sitting at the lower end of its range (2.60% - 3.00%). 

------------------------