A little background. The first quarter of 2019 turned into a very favorable one for U.S. markets, including fixed income. Interest rates have been generally falling for most of 2019 and the overhang by investors that we are in a "rising interest rate environment" appears to be gone.
In the first quarter, the Bloomberg Municipal Index returned 2.90% but high yield munis have returned 3.83%. The main drivers of that have been strong retail demand, reduced supply because of tax reform, and the Federal Reserve pivot removing that interest rate overhang mentioned before.
In addition, given the fund flows out of equities (despite the strong rally), the rebound since the bear market in the fourth quarter isn't believed by investors. This is shifting some investors to invest more defensively into higher quality investments like municipal bonds.
Municipal closed-end funds ("CEFs") have seen a remarkable rally in the first 3.5 months of this year. There are about two dozen funds already up double-digits on price thanks to significant discount tightening. Meanwhile, NAVs are up 3-5% so far this year, total return.
Many discounts were at double-digits at the start of the year but have closed materially. In our January muni update, we discussed that the analysis should take a "total return" as a mean reversion trade was likely to occur. In addition, we noted that we thought discounts might tighten beyond the 52-week averages thanks to the pivot of the Fed in January.
However, in our most recent update to members, we noted that the reversion trade, for the most part, is over. And now, a shift back to distribution sustainability is again paramount. Given the multitude of cuts to PIMCO muni CEFs on the first of April, we think this statement has become more important. PIMCO as a sponsor has probably the stickiest distributions among any institution. Their distributions, in some cases, have been constant for more than a decade. Thus, if they are having to cut, we believe it is important to move back to fundamentals over discounts.
We run our regression modeling on the muni space each month to find out which funds are cheap relative to the space as a whole. The modeling shows that most funds are near their warranted discounts. This lends to reason why we want to focus on highly sustainable distributions that are 4.90% or higher with a majority in investment grade.
Our analysis tracks the monthly UNII and EPS releases of the major sponsors of Nuveen, Blackrock, PIMCO and others. The trends in these figures can give us a read on which funds will cut and which appear to be sustainable.
One of our top picks is Blackrock Investment Quality Municipal Trust (BKN)and we will go through 7 reasons why we like it.
Reason #1: Munis will see strong demand, reduced supply
Demand for munis is only likely to increase as investors need to reduce their taxable income. Demand has already outstripped supply by a significant margin while supply is down ~25% because of advanced refunding being stripped out because of the tax reform act of 2017.
The SALT cap on state and local tax deductions is forcing many high income investors to increase their allocation to municipals. California, New York, Connecticut, and New Jersey, along with other high tax states are seeing record demand levels and lower yields despite the higher credit risk.
This dynamic is unlikely to change any time soon unless congress removes the cap on the SALT deduction.
Reason #2: Diversification Potential | A Natural Hedge
Munis tend to zig when other assets (like stocks) zag. That was the case for most of the fourth quarter when equities entered a bear market. Meanwhile, both tax-free and taxable municipal debt performed well providing a natural downside hedge for your investments. Meanwhile, you're collecting a decent tax-free yield.
Municipal bonds can provide a volatility dampener for your portfolio thanks to historically low correlations to other asset classes. This includes both ends of the spectrum with a low correlation to equities and treasuries.
Reason #3: Solid Risk-Return Trade Off
The volatility in municipal bonds is very low (especially in the last couple of years). Municipal CEFs have very low NAV volatility as indicated in the chart below. Price volatility can be exacerbated thanks to lower liquidity in some of the smaller names and retail investor sentiment.
That lower risk is complimented by a very strong return level that is mostly tax-free. Over the last 5 years, the NAVs of the national muni closed-end fund space have returned 5.90% per year. Even over the last 3 years when we were in a rising rate environment, NAVs gained about 3.23% per year, again mostly tax free.
Reason #4: The tax advantages
Remember, the benefit of investing in municipals is that the interest is tax free at the Federal level. For those in the highest bracket of 37%, a 3% yield is really equivalent to 4.76% on the taxable side. That is roughly what you get in the BBB portion of the investment grade corporate world. And yet, the default rate is far lower in the municipal space.
Reason #5: Munis have outperformed during in past hiking cycles
If we are still in a hiking cycle, historical information does show that munis tend to outperform corporates in those environments. Additionally, we think the steepness of the muni curve (long rates yield more than shorter rates) makes it a more attractive place to put capital than treasuries.
From PIMCO: Munis have thrived in late-cycle conditions:
Despite some “flashing orange” macro signals, PIMCO’s economic outlook for 2019 is broadly supportive of the municipal asset class, which has tended to perform well in late-cycle environments. Past periods of rising rates – including in 2018 – have highlighted the sector’s diversification benefits and outperformance relative to mainstream stocks and bonds.
Blackrock Investment Quality Municipal Trust (BKN)
Net assets: $367M
Average Daily Volume: 39,000 shares
Percent Leveraged: 40.1%
Effective Duration: 11.92 years
Yield To Worst: 5.57%
Percent Insured: 9.55%
Percent AMT Bonds: 8.13%
Management fee: 0.79%
Investment Objective: to provide high current income exempt from regular federal income tax consistent with the preservation of capital. The Trust seeks to achieve its investment objective by investing at least 80% of its assets in municipal obligations exempt from federal income taxes (except that the interest may be subject to the federal alternative minimum tax). Under normal market conditions, the Trust invests at least 80% of its assets in securities rated investment grade at the time of investment. The Trust may invest directly in such securities or synthetically through the use of derivatives.
Nearly all of the credits are investment grade with just ~10% non-investment grade or unrated.
The percentage allocated to the more troubled states is relatively low (unless you include California in that category). New Jersey and Illinois account for less than 12% of the total portfolio.
Reason #6: The Call Schedule:
Probably the most important consideration is the amount of credits that are slated to be called. As rates have fallen in the last six months, we are again in a position where a large portion of those issues from ten years ago get called away and refunded at a lower rate. BKNs call schedule is very favorable with just ~11% potentially getting called away in the next two years. Many funds we looked at had figures of 20-30% of the portfolio callable in the next 24 months. In those funds, a distribution cut is almost certain.
The top sectors include safer areas like transportation, school districts, state tax-backed, and local tax-backed. Pre-refunded are those that have already been replaced but yet to be called.
Reason #7: The Juicy Yield
BKN is one of the few funds that have not cut their distribution in the last year and even paid a very small special distribution this past December. The fund pays a monthly $0.057 per share payment of which 100% is classified as net investment income and thus not subject to any taxes. The current yield is 4.80% for a tax-equivalent yield of 8.11%. High income investors (those with a marginal tax rate above 37% which requires joint filing income of $600,001) should ask themselves if they can find a better risk-return trade off.
Reason #8: Solid Fundamentals
The fundamentals of that distribution are very solid. The distribution is covered with 101.9% net investment income over the payout. That coverage ratio has remained relatively stable over the last 6 months. Month-to-month changes the coverage can be more related to the muncipal space itself rather than fund specific issues.
(Source: Author's calculation)
But most important for muni CEFs are the UNII levels. BKN is one of the rare funds that have increased their UNII balance for every month since July. That growing UNII helps to stave off any need to cut the distribution. Additionally, the absolute level of UNII at over 7 cents can be thought of as a massive safety net for the payment.
(Source: Author's calculation)
Reason #9: The Discount
While the fundamentals are strong, we always want to buy when the discount is attractive. When we first issued this report to members, the discount was at 9.47% and has closed by approximately 1 point since. Still, we think we could be heading towards 52-week highs in discounts as we have realized in other names.
What is likely holding it back is the distribution yield of 4.80%, which is a bit lower than other more popular funds at or above 5.00%. But the Net Investment Income ("NII") yield using coverage ratio averages of the last several months means the true yield of the fund is actually closer to 4.95%.
In aggregate, we think this is a total return play thanks to the cushion on the discount along with the higher NII yield.
Remember why you invest in munis CEFs- to generate steady streams of tax-free income and compound it year after year. The non-quantitative benefit of muni CEFs are that natural downside hedge they can offer, especially on the high quality funds (non-high yield).
Given the drop in distribution yields, we may need to drop our yield expectations a bit. Previously, a 5% distribution yield threshold was attractive but with tighter discounts, 4.8% or 4.9% may be the new normal. A 5%+ distribution rate is going to be hard to maintain as discounts evaporate and interest rates fall.
When looking at these funds, our goal is to find the perfect fund [high coverage, high UNII, strong NAV performance, wide discount, favorable call schedule, and not overpriced versus our model]. BKN is one example of the results of the research.
We released our muni report with more than half a dozen high-quality funds that we think investors should look at and possibly allocate capital. Our goal is to release them over the next couple of weeks. However, as we've seen with BKN and NMZ, it hasn't taken long for the market to realize their worth and shrink the discount accordingly.