Closed-End Fund Outlook – Sector Analysis – Municipal Bonds

by Neil Azous, Chief Investment Officer

Summary

Potential Benefit of a Municipal Bond Closed-End Fund Discounted Yield
Municipal Bond Closed-End Funds Discounts At Widest Levels Of This Cycle
Risk-Adjusted Return Comparison
Municipal Bond Market Update
Overweight Municipal Bond Closed-End Funds

At Rareview Capital, we use closed-end funds as our primary investment vehicle to construct portfolios because they can potentially deliver returns through three different channels: principal 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-third 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.

Yesterday, in a post titled, “Why We Are Still Not Afraid Of Higher Yields”, we showed you how we use our Federal Reserve model to forecast interest rates.

Today, supported by this interest rate view, we tell you why we believe municipal bond closed-end fund potentially offer the best opportunity across asset classes.

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

We feel that part of our job is to proactively educate given the specialized nature of closed-end funds.

One of the key reasons why closed-end Funds have long been valued is because that in addition to owning higher 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 because you are purchasing $1 of distributions at $0.88 on the dollar.

In this case, if we had purchased a closed-end fund with a ~12% discount, we can get ~13% more in yield than we would have if we had bought the same underlying assets.

For an overview of how this adds incremental yield to a portfolio, see the below chart. The closed-end fund we reference 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 less than 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 4.68%.

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 5.27%, which is about 1.4x the un-levered benchmark yield.

Municipal Bond Closed-End Funds Discounts At Widest Levels Of This Cycle

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, on a Z-score basis, municipal-bond closed end funds have the widest discount of any sector.

The below illustration shows tax-exempt municipal bond closed-end fund discounts for our target universe as the most appealing on an absolute basis in the last two years and have surpassed the wide discounts seen shortly after the Presidential Election. In fact, for most of our current target holdings, their respective discounts are at or near their widest in their 15- to 20-year history.

Risk-Adjusted Return Comparison

The taxable equivalent yields in municipal bond and high yield bond closed-end funds are currently the same. Meaning, that the incremental yield pickup for the additional risk of owning high yield bonds is not warranted now. This is a rare occurrence.

Note, a high yield bond closed-end fund historically carries two times the price risk of a municipal bond closed-end fund. Additionally, the historical default rate for municipal bonds relative to high-yield credit is more than 30 times less. Therefore, on a risk-adjusted basis, we believe municipal closed-end funds are more compelling than high yield closed-end funds regarding asset allocation.

For example, since the summer of last year, the risk-adjusted return for owning government-backed debt, such as municipal bonds, has been superior to that of other riskier credit instruments.

Over that time frame, the five most liquid municipal bond closed-end funds NAV’s have had an average Sharpe ratio of 1.14.¹ Conversely, the five most liquid high yield US credit closed-end funds NAV’s have had an average Sharpe ratio of 0.78.²

These statistics may surprise many considering the velocity of the recent fixed income selloff, and the melt-up in the equity market. After all, municipal bonds are very sensitive to interest rates and high yield is a risky asset.

Moving forward, we believe this will continue to be the case. High yield corporate bond spreads are near their historical tights. It will require continued readings of near or above 60 for ISM manufacturing, a return to single-digit equity volatility, earnings growing faster than what has already been discounted because of tax reform (+27% in 2018), and economic growth realizing substantially more than 3% this year for spreads to stay at these levels or tighten.

Conversely, if any of those are not true, it is likely that US government bond yields, including municipal bonds, will stay at current levels or move lower.

We believe that the reward-to-risk profile strongly favors municipal bonds.

Municipal Bond Market Update

There are numerous idiosyncratic factors beyond potentially lower interest rates that suggest municipal bonds could outperform.

Cash: As the return on cash increases, the threshold to invest into safer fixed income assets, such as municipal bonds, will be much lower.
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Historical Precedent: The supply/demand profile, or technical picture, is very favorable. In fact, there is a historical precedent for outperformance – the Reagan tax cuts. Back in 1986, when President Reagan initiated sweeping tax reform, which also removed the tax deductibility for advance refunding, a substantial amount of future municipal supply was pulled forward into that tax year, and municipal bond supply dropped by about 30% in 1987 after it was signed into law. It is expected that municipal issuance will decline by about 25% in 2018. To put that in Dollar terms, issuance is now expected to drop by more than $100bn this year.

a. Note, the net supply for the year-to-date is negative at $9.8bn. Also, the visible 30-day supply is at $13bn. Historically, monthly supply is closer to ~$20-30bn. (Source: Bloomberg, dated March 12, 2018)

New Buyer – Liquidity Treatment of Municipal Debt: Municipal debt may become more attractive for banks to hold to meet liquidity rules. The liquidity coverage ratio originally excluded U.S. municipal debt. Yet a bipartisan bill set to pass the Senate and with decent odds in the House would allow some muni debt to be treated as high-quality liquid assets.
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State Level Opportunity: The tax law changes capped the state and local tax deduction at $10,000 per year, which means a higher tax burden for wealthier people in high tax states. For states such as California and New York, the federal and state tax exemption for municipal bond income is very attractive and could draw further inflows.

Overweight Municipal Bond Closed-end Funds

So, given our framework on interest rates, which shows that there is a justification to hold more interest-rate sensitive assets in the Closed-End Fund market, how are we taking advantage of it?

We are primarily overweight municipal-bond closed-end funds that we believe will be resilient to future interest rate hikes by the Fed. Firstly, because we believe the fixed income market is already discounting an excess risk premium for future interest rate hikes. Secondly, because the municipal bond closed-end fund market currently has some of their widest discounts in history.

Finally, we are selectively adding New York and California closed-end funds to the mix due to the recent tax changes that incentivize wealthier investors in high tax-states to add these state-specific municipal bonds to their portfolios.

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If you are interested in learning more about how we use closed-end funds to construct portfolios in separately managed accounts (SMA), including our Managed Municipal Bond (Tax-Exempt Income) strategy, please call us at 203-539-6067 or email us at info@rareviewcapital.com.

Footnotes:

¹Source: Rareview Capital, measurement period from July 1, 2017 to February 28, 2018, backup data available upon request.

²Source: Rareview Capital, measurement period from July 1, 2017 to February 28, 2018, backup data available upon request.

Past performance is not necessarily indicative of or a guarantee of future results

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.

There are risks inherent in any investment including the possible loss of principal. There can be no assurance that separate account objectives will be achieved. Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund’s investment return and principal value will fluctuate so that an investor’s shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund’s portfolio. There is no assurance that a Fund will achieve its investment objective. Past performance does not guarantee future results.

Products or terminology:

Nuveen Quality Municipal Income Fund (symbol: NAD)
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.
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.