Amid concerns around the coronavirus and oil prices, market volatility has driven investors into higher quality assets, pushing down bond yields. For example, the 10-year US Treasury yield has moved down 134 (1.34%) basis points year to date, hitting as low as 0.54%1. In our opinion, major central banks seem set on maintaining easy monetary policies, meaning interest rates and bond yields look more likely to linger near historic lows.
In this environment, finding income remains at the top of investors’ minds. Municipal bonds have long offered multiple benefits to investors, including tax advantages and attractive income potential both on a relative and tax equivalent basis. Municipal closed-end funds (“CEFs”) can further enhance income potential through active management and taking advantage of the vehicle’s “closed” structure.
Strong demand for munis
Municipal bonds are known for their high credit quality, low default rates and tax advantages. Munis have performed well this year (up 3.1%2 through February 28) as investors moved into higher-quality assets given global growth concerns, and more recently, worries surrounding the coronavirus pandemic. In fact, municipal bond mutual funds have seen 60 straight weeks of net inflows3.
When evaluating municipal bonds, it is important to consider their tax equivalent yield. Municipal bonds are exempt from federal taxes and investors can potentially receive additional tax benefits by purchasing state and local tax-exempt bonds issued by states and municipalities in which they reside. This can be particularly beneficial for residents of states with higher income tax rates, such as New York, New Jersey, and California.
A potential boost from CEFs
Investors looking to be more aggressive in their search for income may benefit from adding municipal CEFs to their portfolio. Unlike open-ended mutual funds, the “closed” structure provides greater flexibility in the types of investment strategies portfolio managers can use. Because CEFs trade directly on the stock exchange, one investor to another, managers don’t have to worry about deploying new cash inflows and or forced selling from cash outflows; this allows them to stay invested for the long term. If the bonds being purchased are yielding less than the current portfolio, this could negatively impact the fund’s distribution rate. The CEF structure also allows for the use of leverage, which can enhance income and return potential.
Given these structural benefits, municipal CEF’s are currently offering a median tax equivalent yield of 8.5%, which is higher than the current yield of individual municipal bonds or municipal mutual funds, as the chart below shows. They have also outperformed their open-end peers in 20 of the last 25 calendar years, on a net asset value (“NAV”) basis, including average annual outperformance of 2.4% over that period.
Finding income at a discount
Investors should also consider that municipal CEFs are exchange traded products and can trade at premiums/discounts. At any given point in time, a CEF’s share price may be above (at a premium to) or below (at a discount to) its underlying NAV. Premiums or discounts occur for a number of reasons, including market and investor sentiment and fund-specific characteristics such as performance and distribution rate.
Since 2016, distribution rates and stability of that income has been a focus of municipal CEF investors as rising leverage costs (as measured by the SIFMA Municipal Swap Index (“SIFMA”)) reduced fund earnings, resulting in distribution reductions across the industry and widening discounts. However, more recently, leverage costs have fallen, increasing distribution stability and driving discounts narrower (Exhibit 3).
As with buying any item “on sale,” it may be advantageous to purchase a fund when it is trading at a discount to its NAV, as each dollar invested purchases more than a dollar of net assets. What’s more, if the discount begins to narrow, investors may also have an opportunity for capital appreciation.
This scenario played out in 2019, as municipals performed well given a favorable market backdrop and falling interest rates. Municipal CEFs began the year at historically wide discounts, and then narrowed considerably; for the year, the average NAV was up 10.8% and the average market price was up 19.5% (see chart below). So investors would have seen significant capital appreciation in addition to an income stream.
Where are we today? Currently, the median discount for municipal CEFs is -12.9% compared to the 20-year median of -5.0% (Exhibit 4). We believe that this represents an opportunity for long-term investors to seek attractive levels of tax-exempt income and potential price appreciation.
1 As of 3/9/20.
2 Bloomberg Barclays Municipal Bond Index. Past performance is not indicative of future results.
3 As of 3/6/20.