Closed-End Fund Outlook – Volume 4

November 08, 2017

by Neil Azous, Chief Investment Officer

 

Summary

  • What Interest Rate Volatility Is Saying
  • Where We Are At In The Interest Rate Hiking Cycle
  • What Is Our Federal Reserve Model Saying?
  • Potential Benefit of a Municipal Bond Closed-End Fund Discounted Yield
  • Overweight Municipal Bond Closed-End Funds

 

At Rareview Capital, we use closed-end funds as our primary investment vehicle because they can potentially deliver returns through three different channels: capital appreciation, income, and the narrowing of a fund’s discount to its net asset value (NAV).

As a way of background, two-thirds of the closed-end fund universe is fixed income oriented. Also, municipal bonds make up roughly one-fifth of the assets in the closed-end fund market. Historically, we have found that changes in interest rates explain close to 99% of all movements in broad municipal bonds over the intermediate-term.

So, when it comes to investing in closed-end funds, especially the municipal bond sector, we believe the ability to forecast interest rate risks in a model-driven way is critical.

 

What Interest Rate Volatility Is Saying

Following the formal nomination last Thursday of Jerome Powell to be the next Chair of the Federal Reserve, bond market volatility crashed. In fact, it was the third largest weekly decline in interest rate volatility in history. Here are the salient data points as of last Friday’s closing prices:

  • US Fixed Income – Front End: Implied volatility in the 4th Eurodollar future (ED4), a proxy for uncertainty regarding the Fed’s forward path, hit a cycle low on Friday and is now at the lowest level since the 2005-2006 period, near when the last tightening cycle ended.
    ABC
  • US Fixed Income – Long End: Realized and implied volatilities in the 10-year US Treasury future (TY1) closed at 2013 pre-taper tantrum lows. The current 30-day rolling realized volatility at 2.84% shows that Treasuries do not get any less volatile.

Here are what these low volatility signals mean to us:

 

US Fixed Income – Front End

The bond market is conveying that the potential outcomes from future Fed policy are constrained as we approach and rise above the neutral rate soon, and reach the end of the economic and credit cycle. For example, at its December FOMC meeting when the Fed likely raises interest rates by 25 bps, it will be the first time this cycle that the real Fed funds rate is positive, typically a late or end-of-the-cycle phenomenon.

Any potential major shifts in interest rates will need to be structurally driven, such as the 2013 Taper Tantrum, the 2016 Trump election win, or something above and beyond the fiscal narrative associated with US tax reform. A potential Mueller-Trump constitutional crisis could be another example.

US Fixed Income – Long End

The return to the 2013 pre-taper tantrum lows in volatility in the long-end of the yield curve is conveying that tax reform is not a greater impact on growth and inflation than what has already been reflected in the three months that followed the Presidential Election.

While tax reform should shift the balance of risks for future growth to the upside from the downside, it does not convey a new structural regime yet, especially after the details were released last week.

Since the long-end of the yield curve is more sensitive to inflation dynamics, what remains is crude oil. Tactically, investors will need to discount the potential inflation impact from a sustained higher price of crude oil – ~10 bps higher in 10yr inflation expectations for every 10% sustained move higher in crude oil – should the barrel continue to make new higher prices.

Ultimately, the low bond volatility signals that this year’s range in the 10yr US Treasury – 2.04% to 2.63% – should hold for the remainder of 2017 and into 2018.

Ironically, the average US Treasury 10-year yield in 2017 is 2.32% vs. Friday’s close of 2.33%. The low volatility reflects the reversion to the mean of this year’s range.

 

Where We Are At In The Interest Rate Hiking Cycle

Take a look at this simple grouping.

The interest rate hike story can be put into four quadrants.

Here’s how we think about each one:

  1. Cutting Interest Rates: easing policy by cutting interest rates due to a flat yield curve, disturbed financial conditions, or a potential economic slowdown.
    ABC
  2. Lower for Longer: An extended delay in raising interest rates, or “one and done.”
    ABC
  3. Gradual Pace: A more gradual pace of interest rate hikes, or about two or three per year – which equates to the market pricing the equal probability of an interest rate increase, decrease, or no move at each meeting over the next 18 months.
    ABC
  4. Measured Pace: A measured pace of interest rate increases, or about four or more interest rate increases over a 12-month period.
    ABC
    Sidebar: As a reference point, during the last rate hiking cycle between 2004 and 2006, under Chairman Alan Greenspan, there was a “measured” pace of a 25 bps interest rate hike for 17 consecutive meetings

We are in quadrant 3 right now, and leaning more towards quadrant 4 than 2.

 

What Is Our Federal Reserve Model Saying?

It is most important to know what the market expects to happen in the future relative to our expectations. A prediction, or forecast, of the 10-year Treasury yield is meaningless unless we know what that expectation is relative to the market’s, and how realistic it is that that the path may evolve between now and then.

Using our Federal Reserve model, we can “digitally” recreate every single scenario that is priced into the front-end of the US interest rate market. The ability to recreate the expectations embedded in the US Treasury yield curve with precision is very powerful when it comes to asset allocation, and most importantly whether the risk is greater of higher or lower interest rates.

This bar chart extrapolates the specific probability of a hike “AT” a certain meeting.

Meaning that once the outcome of December’s Federal Reserve meeting is known, what is the probability they hike in March too? Or June?

So, what is the model saying now?

Currently, the market is pricing in the probability – or risk – of the Fed raising interest rates “at least” three times between now and the end of next year, to pricing in the likelihood of going four times

At above 90% for December, the market is now “nearly certain” the Fed will hike interest rates in December, so there is no more downside in bond prices left betting against a December hike.

Sidebar: As a reference point, we view anything above 70% as extreme with 40 days of time value left in the interest rate market as the event becomes digital. There are two CPI reports, one PCE report, asset purchases just beginning to be unwound, and a new Fed chair yet to be confirmed by the Senate. Meaning, a LOT can happen, and there is no margin of error.

March is now above 50% for the first time since it was a tradeable event.

Additionally, the unconditional probability of December and March have edged higher over the last week.

92% (Dec blue bar) + 51% (March blue bar) = 143%

143% / 2 FOMC meetings = 71.5%, or very probable of two interest hikes by March.

 

Potential Benefit of a Municipal Bond Closed-End Fund Discounted Yield

One of the key reasons why closed-end Funds have long been valued is because that in addition to owning high-yielding instruments, you are most often able to purchase them at a discount to their net asset value (NAV).

So, while the funds may pay out the income they earn from their underlying investments at the NAV price, if a fund has a discount, there is the potential benefit from an additional pickup in yield.

For an overview of how this adds incremental yield to a portfolio, see the below chart. The closed-end fund we reference as an example is the Nuveen Quality Municipal Income Fund (symbol: NAD).

Bar 1: Represents the Bloomberg benchmark yield for A-rated 30-year municipal revenue bonds.

Bar 2: Represents the un-levered distribution-at-NAV yield of the Nuveen Quality Municipal Income Fund (symbol: NAD), which is roughly the equivalent of the benchmark yield.

Bar 3: Is the distribution-at-NAV yield, including the 1.38x leverage the Fund uses, which brings the yield up to 4.64%.

Bar 4: Is the distribution yield at the stock price you could buy it. Now that you’ve included the fund’s leverage and its discount, you bring the yield all the way up to 5.14%, which is about 1.5x the un-levered benchmark yield.

 

Overweight Municipal Bond Closed-End Funds

Armed with this knowledge, what can we say about prices moving forward, particularly when we account for factors related to municipal bond closed-end funds?

Currently, in the closed-end fund universe, when looking specifically at fund discounts, we find that the municipal bond closed-end funds are the most compelling.

The below illustration shows tax-exempt municipal bond closed-end fund discounts for our target universe remain the most appealing on an absolute basis in the last two years, and have reached the widest discounts since shortly after the Presidential Election.

Additionally, and more importantly, except for Master Limited Partnership (MLP) closed-end funds, tax-exempt municipal bond closed-end fund valuations remain the cheapest on a relative basis to all other closed-end fund asset classes that we track. This highlights the general disdain for government bonds and any fixed income assets with a high degree of interest rate sensitivity.

Considering that over the course of the year, broad closed-end fund discounts have narrowed, we aim to target the asset classes that have both an attractive fundamental outlook and relatively cheap discounts. The municipal bond sector meets these investment criteria.

Collectively, with a 5.2% pre-tax distribution yield, municipal bond closed-end funds are set up to capture the profile we sketched out above moving forward. Given their wide relative discounts in the closed-end fund universe, it makes the opportunity that much more appealing.

Moreover, the taxable equivalent yields in municipal bond and high yield bond closed-end funds are currently the same. This is a rare occurrence. However, a high yield bond closed-end fund historically carries two times the risk of a municipal bond closed-end fund. Therefore, on a risk-adjusted basis, we believe municipal closed-end funds are more compelling than high yield closed-end funds regarding asset allocation.

Finally, the ability to purchase an asset at a discount is highly valued in the investment world. It is even more beneficial when the Net Asset Value (NAV), or the underlying basket pricing, is readily available each day, as in this case.

Adding in our Federal Reserve model-driven approach for whether there is justification to hold more interest rate sensitive assets, we believe there is scope to be overweight municipal bond closed-end funds in an investment portfolio.


Disclaimer

This material is for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any investment or any other security, including any investment with Rareview Capital LLC (“RVC”) or any of its affiliates or any other related investment advisory services. This material is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. This material does not constitute legal, tax, or investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. In preparing this material, RVC has relied upon data supplied by third parties. RVC does not undertake any obligation to update the information contained herein in light of later circumstances or events. RVC does not represent the information herein is accurate, true or complete, makes no warranty, express or implied, regarding the information herein, and shall not be liable for any losses, damages, costs or expenses relating to its adequacy, accuracy, truth, completeness or use. This material is subject to a more complete description and does not contain all of the information necessary to make any investment decision, including, but not limited to, the risks, fees and investment strategies of an investment. All investments carry a certain degree of risk, including the possible loss of principal. There is no assurance that an investment will provide positive performance over any period of time. There are specific risks that apply to investment strategies. Closed-end funds frequently trade at a discount to their net asset value. These risks should be reviewed carefully before taking any investment action. Since no one investment style or manager is suitable for all types of investors, this site is provided for informational purposes only. The statements contained herein are the opinions of RVC. This site contains no investment advice or recommendations. Individual investor results will vary. Rareview Capital LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. Past performance is no guarantee of future results.

 

Products or terminology:

  • Nuveen AMT-Free Quality Municipal Income Fund (symbol: NAD):
    ABC 

    • Securities offered through Nuveen Securities, LLC, a subsidiary of Nuveen, 333 W. Wacker Drive, Chicago, IL 60606. Nuveen is an operating division of TIAA Global Asset Management. TIAA Global Asset Management provides investment advice and portfolio management services through TIAA and its affiliated registered investment advisers.
      ABC
    • Returns quoted represent past performance which is no guarantee of future results. Investment returns and principal value will fluctuate so that when shares are redeemed, they may be worth more or less than their original cost. Current performance may be higher or lower than the performance shown. Total returns for a period of less than one year are cumulative. Returns without sales charges would be lower if the sales charges were included. Returns assume reinvestment of dividends and capital gains. For performance current to the most recent month-end visit nuveen.com or call 800.257.8787.