Weekly Review: Municipal Bond CEFs - A Slight Decline From The Record Highs

A slight decrease for the municipal bonds, but if the situation around the trade war remains complicated, we may expect new record high in the next weeks.

We continue to follow the most important yields and municipal/Treasury spread ratio.

Most of the funds from the sector are trading at positive Z-scores, and we do not see a statistical edge to include some of them in our portfolio.

Over the past few months, most of you have noticed our increased activity in closed-end funds as the inflow of volatility finally shook them up and created various arbitrage and directional opportunities for active traders like us.

Currently, we are cautious when we choose our long positions, as most of the closed-end funds which hold municipal bonds have lost their statistical edge and are traded at positive Z-scores. However, there are several interesting pair trade opportunities which can be traded. For the conservative market participants with a longer investment horizon, I still see interesting dividend opportunities which are trading at high discounts

For several weeks, we were observing a very strong performance from the municipal bonds. Over the past week, the main benchmark reported a slight decrease in its price. The iShares National Muni Bond ETF (MUB) fell by $0.15 and finished the Friday session at $115.15 per share. Although its price remained in negative territory, the main index is very close to its all-time high which gives us a signal that the market participants are very interested in safer assets. Furthermore, the trade war between the U.S. and China does not seem close to a resolution and this may be a factor to see new highest levels from the municipal bonds in the next several weeks.

As you know, we follow the performance of the U.S. Treasury bonds - considering them a risk-free product - with maturities greater than 20 years: the iShares 20+ Year Treasury Bond ETF (TLT). The reason for that is the strong correlation between these major indices and the chart below proves it. Additionally, a statistical comparison is provided by our database software:

Investing in municipal bonds is popular because they have the potential to offer higher yields than similar taxable bonds. If an investor wants to know whether muni bonds are cheap in comparison to taxable bonds or Treasuries, they could find out by comparing them. However, this method does have its limitations, and the investor should perform a more thorough analysis before making a decision:

The Municipal/Treasury spread ratio, or M/T ratio as it is more commonly known, is a comparison of the current yield of municipal bonds to U.S. Treasuries. It aims to ascertain whether or not municipal bonds are an attractive buy in comparison. Essentially, an M/T ratio north of 1 means that investors receive the tax benefit of muni bonds for free, making them even more attractive for high net worth investors with higher tax rate considerations.

The narrowing spread and 3-month LIBOR are important for the leveraged municipal funds, and they can be highly affected by them. The 3-month LIBOR rate is a commonly used funding benchmark for the municipal bond CEFs.

Data by YCharts

Several funds announced their dividends:

1. Biggest price decrease

2. Biggest price increase

1. Lowest Z-Score

I would like to start our review with the fact that almost all of the municipal bond closed-end funds reported a slight decrease in their net asset values on a weekly basis. Only 4 of 136 funds reported an increase in their NAVs. Compared to the previous time, we do not see any significant changes in the funds which have the lowest Z-score in the sector. As you know, the Z-score shows us how many times the current discount/premium deviates from its mean for a specific period.

BlackRock Maryland Municipal Bond Trust (BZM) reported another slight decrease in its price after the announced dividend cut and it is among the funds with the lowest Z-scores. The management team decided to decrease the monthly distribution from $0.0474 per share to $0.0364 per share.

To be honest, I do not see anything very attractive which I can buy at negative Z-score at that moment. PIMCO New York Municipal Income Fund II (PNI) remains one of the interesting funds which you can include into your portfolio at price equal to its net asset value and one of the lowest statistical parameters.

2.

Highest Z-Score

The recent interest rate cut is a positive fact for the prices of the fixed-income assets with a relatively long duration. Municipal bond closed-end funds are exactly this type of assets, and we can admit that the increase in their prices was expected. Nevertheless, I notice too high optimism in some of them. Z-score is a tool which can help us to identify relatively expensive funds. From our perspective, Z-score above 2.00 points is a signal to re-allocate your money. A fund is expected to trade between a Z-score of -2.00 points and 2.00 points for 95.5% of the time. So, when we see outliers, maybe there is temporary mispricing.

Another very important point which I would like to highlight is the topic of the earnings and the dividends. In other words, how to avoid "dangerous" funds which can decrease their dividend. The easiest way is to monitor the earnings/coverage ratio and the UNII/share balance. If both of them become negative for several consecutive periods, the dividend cut seems a very realistic event.

Let us take Invesco Pennsylvania Value Municipal Income Trust (VPV) as an example. It has a Z-score of 2.20 points, and I suppose most of the market participants buy it at the current price due to its yield of 4.75%. If you check the latest earnings per share, you will notice that it is not high enough to cover the monthly dividend. This may be an important factor to see the dividend cut very soon. So, from each angle, the closing of your long position in VPV seems the right choice.

The average one-year Z-score in the sector is 1.13 points. Last time, the average Z-score of the municipal sector was again 1.13 points.

3.

Biggest Discount

Many of the funds are traded at an attractive discount. I will highlight the fact that most of them are state-specific. The national munis are currently traded at a smaller discount, most probably due to their diversified portfolio.

The Delaware Investments Minnesota Municipal Income Fund II (VMM) is the new leader of the ranking and it has a discount of 12.87%. If you want to extend your investments in Minnesota, then VMM may catch your attention. The current yield of the fund is 3.43%, and the dividend is fully covered by the latest earnings. The credit quality of VMM is more than impressive, as 52.01% of its investments are rated with "AAA" and "AA".

4.

Highest Premium

Probably, you noticed the dominance of the PIMCO funds. The market participants constantly pay a premium for them due to their satisfying past results and faith in the quality of the management team.

Last time, I shared with you my opinion that Western Asset Managed Municipals Portfolio (MMU) is overpriced and it is not a bad idea to close your long positions. Over the past week, the price of MMU was among the worst performers and fell by 2.83%. The management team of the fund announced a dividend cut from $0.0580 per share to $0.0505 per share which will be effective from September.

The average discount/premium of the sector is -5.00%. Last time, the average spread between the prices and the net asset values of the funds was -5.07%.

5. Highest

5-year Annualized Return On NAV

The above sample shows the funds which outperformed their peers. As you see, most of the participants are sponsored by Pacific Investment Management Company LLC, and these good results are the reason why the market participants are willing to pay a premium for them on a regular basis. The average return on net asset value for the past five years for the sector is 5.49%.

6.

Highest Distribution Rate

:

The table shows the funds with the highest distribution rate on price. Additionally, I have included here the distribution rate based on net asset value. Most of the market participants find the second metric to be more important. The average yield on price is 4.11%, and the average yield on net asset value is 3.91%.

My recommendation here is to check also the earnings coverage ratio and the UNII/share balances of the funds which offer higher yields. I am saying it because if the earnings are not high enough to cover the dividend, it is possible to see a decrease in the distribution which is going to affect the yield of the funds, and it is very likely to see a decrease in its price.

7.

Lowest

Effective Leverage %

The average effective leverage of the sector is 35.6%. Logically, most of the funds with lower effective leverage have lower distribution rates compared to the rest of the closed-end funds. Seven funds from the sector have effective leverage equal to zero.

Above, you can find the chart of the funds with the lowest effective leverage and their yields on net asset value. If you are not a big fan of the high leverage, this chart will be very helpful.

Compared to the previous years, the discounts of the closed-end funds holding such products have significantly widened, but we remain cautious when we select our long positions due to the high Z-scores in the sector. However, there are several interesting trades which you can review if you use the discount as a metric.

I/we have no positions in any stocks mentioned, but may initiate a short position in PCQ over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.