AN ALTERNATIVE APPROACH TO MUNI BONDS The chart to the right shows the after-tax yield (assuming highest bracket) and the duration of some fixed income options. As a reminder, duration is a measure of a bond s price sensitivity to interest rate changes. A duration of 10 would means that a bond s price would fall roughly ~1 if its yield rose 1%. Relative to their duration and credit quality, munis are very attractive for 20 wealthy investors to hold in taxable accounts. 15 A big benefit of individual bonds, over bond funds, is that you can 10 hold individual bonds until maturity to ensure zero loss of principal. The majority of bond funds set a maturity level, say 7 years, and 5 constantly turnover their portfolio to maintain this maturity level. 0 This means the bond fund never gets paid back unlike a traditional bond, and the price of the fund rises or fall based on interest rate movements. Fixed Fixed Income Income Duration and and Yield 20 7. 15 5.3% 5.3% 10 3.5% 3.5% 5 1.8% 1.8% 0 0. Muni CEFs High Yield Inv Grade LT Treasuries Corp Bonds Corp Bonds Muni Bonds High Yield Inv Grade LT Treasuries 0. Duration Corp Bonds (LHS) Corp After-Tax Bonds Yield (RHS) Duration (LHS) After-Tax Yield (RHS) There is one exception to this rule. There are a small number of bond funds that set an explicit date when the entire portfolio will mature, and then the fund s net asset value is returned to investors, just like how principal is returned with an individual bond. These are called target maturity bond ETFs. The graph below shows how in the last year of a target maturity ETF s existence, the amount of outstanding bonds decreases and the amount of cash from principal repayment increases. There are a lot of benefits to target maturity ETFs over buying and holding individual bonds to maturity. First, each ETF holds hundreds of investment-grade muni bonds as opposed to a single bond issue. This helps mitigate credit risk and eliminates the need to do due diligence on individual municipalities. Two, with single issuer credit risk eliminated, there s no need to pay a broker or advisor to pick muni bonds for you. Third, target maturity ETFs are much more liquid than individual bonds. In the event you did need to sell some of your bond holdings, you d be able to sell the ETF just like a stock, incurring minimal transaction costs. This is in contrast to selling an individual bond to a bond trading desk, where retail investors trading small quantities will get hit with material price spreads. In short, target maturity muni bond ETFs mature like a bond, are diversified like a fund, and trade like a stock. I think they re an excellent substitute for owning individual muni bonds and they re a great complement to the next component of my muni bond strategy.
A DEEP DIVE INTO MUNI CLOSED-END FUNDS Closed-end funds (CEFs) are unique investment vehicles that receive little attention and are subject to irrational mispricings that investors can take advantage of. We re experiencing one of those mispricings right now, but before I dive into why they re currently attractive, let me explain exactly what CEFs are. CEFs issue a finite number of shares when they IPO and trade intraday on the secondary market just like common stocks. This is different from mutual funds that have to both buy and sell investments as investors purchase or redeem fund units. Mutual funds always trade at their net asset value (NAV), which is the total value of their investments. Since CEFs trade on the market after issuance, they can either trade above or below the net asset value of the CEF s underlying portfolio. ETFs are similar, but the main difference between ETFs and CEFs is that ETF issuers have the ability to create or redeem ETF units if the value of the ETF strays from its net asset value. CEFs only issue shares once and thus there s no way for market makers to quickly arbitrage the difference between a CEF s share price and its NAV. CEFs can also use leverage. They are limited to borrowing a third of their total portfolio exposure. So for example, a fund with $100 of investments could at max borrow $50, to total a $150 portfolio of investments. This ability to borrow is especially relevant for bond investors, as a portfolio of bonds yielding 4% can be leveraged up to yield 6%. Obviously leverage magnifies both gains and losses. Think of CEFs as extremely simple companies. With most companies, you forecast cash flows, estimate the future value of the company, and assign a price to their shares based on your forecasts. With CEFs, you know exactly what the company is intrinsically worth: the net asset value of its portfolio. There are CEFs that invest in stocks, corporate bonds, real estate, and a number of other asset classes. But by far the most popular category of CEFs invests in municipal bonds. The biggest muni CEF issuer is Nuveen, a company formed in 1898 initially as an underwriter for individual muni issues. Nuveen played an instrumental role in both popularizing muni bonds as investments and promoting the CEF structure. So why am I bringing attention to this relatively obscure part of the investment universe? Because I think muni CEFs are presently one of the most attractive investments for U.S. investors in taxable accounts. To the right is the historical discount or premium to NAV of one of Nuveen s largest CEFs. As you can see, it s trading for discounts last seen in 2014/2015, and before that, the Historical Muni CEF Discount/Premium 2 1-1 -2 2000 2003 2006 2009 2012 2015 Discount or Premium to CEF Net Asset Value depths of the financial crisis. A current discount of ~12% means you re paying 88 cents for a dollar worth of assets.
MOV E M EN T R E SE A RC H N OT E WHAT DRIVES MUNI CEF RETURNS? Here s how to think about the returns from municipal CEFs. They re all surprisingly similar in that they lever up portfolios of long-term muni bonds. The average muni CEF owns muni bonds yielding 4.5%. Leveraging this up by 5 yields 6.8%. A portfolio yielding 6.8% bought at a 1 discount yields 7.5%. Then all fees have to be deducted. Most muni CEFs have management fees of 0.. This pays for analysts to perform credit analysis and pick the most attractive muni issues. Then the CEF has to pay interest on their borrowed money. Just as corporate borrowers reference LIBOR, muni borrowers reference SIFMA. SIFMA is a short-term lending rate for the muni market, and CEF issuers typically borrow at 0.8% plus SIFMA. With SIFMA currently at 0.6%, this equates to them paying 1.4% for their short-term financing. Since half of their portfolios are levered, that s ~0.7. So ~1.45% in total management fees and interest expense has to be deducted from their net portfolio yield of 7.5%. We re left with a portfolio of munis, when bought at a significant discount like they are now, yielding ~6% after all fees. This yield is completely exempt from federal income tax since it comes from municipal bonds. For a high income earner, this net 6% is equivalent to 1 earned elsewhere from corporate bonds, Treasuries, or short-term capital gains in other assets. In my opinion, it s going to be extremely difficult to generate 1 per year from conventional assets going forward. Thus far we ve addressed what CEFs are and how to determine their true yield. But how do we determine if they re worth allocating to? Two main things drive muni CEF returns: 1) movements in long-term interest rates and 2) the magnitude of a CEF s premium or discount. Let s take a look at those two variables. 6M6M Chg in in 30-Year Treasury CEF Disc/Prem Chg 30-Year Yields &Yields Munivs. CEF Disc/Prem 2% 2% 5% 5% 1% 1% -5% -5% -1% -1% -1-1 -2% -2% 2001 2001 2004 2004 2007 2007 6M 6MChg Chgin in30-yr 30-YrYield Yield(LHS) (LHS) 2010 2010 2013 2013 2016 2016-15% -15% MuniCEF CEFDiscount/Premium Discount/Premium(RHS) (RHS) Muni Let s focus on the green line first. This shows the six-month change of the yield on 30-year Treasury bonds. For example, the 30-year yield has recently risen ~0.4, moving from 2.6% six month ago to 3.. As yields go up, bond prices (and by extension, muni CEFs) fall in value. The blue line shows the discount or premium to NAV of Nuveen s most popular CEF. The worst environment to buy muni CEFs in is after long-term yields have substantially fallen and when CEFs sell for premiums to their NAV. On the flip side, the ideal environment for muni CEFs is after long-term yields have spiked and fund discounts are extreme. This is exactly where the muni CEF market finds itself now.
MOV E M EN T R E SE A RC H N OT E A SIMPLE MUNI MODEL Let s now take a look at a simplified version of my muni CEF framework. It takes the two key variables, changes in long-term yields and CEF discounts/premiums, and calculates a percentile for each. For example, when the highest six-month change in 30-year yields was reached at 1.6%, that percentile (the blue line) was. This was in the summer of 2009 as investors embraced risky assets and bonds sold off hard, causing the 30-year yield to rise from 2.7% to 4.3%. In contrast, this percentile was ~9 when long-term yields collapsed from 4.5% to 3.. This was during the 2011 debt ceiling crisis when investors chased safe assets like Treasuries. The orange discount/premium line works the same way. A low percentile reading like the current 17%, occurs when CEF discounts are abnormally large. 6M 30-Year Yield Chg & Disc/Prem Percentiles 10 10 10 10 5 5 5 5 2005 2005 2008 2008 Discount/Premium (LHS) 2011 2011 2014 2014 6M 30-Yr Yield Chg (RHS) The below graph creates an average of the above two percentiles, and also plots the forward 12-month total return of the previously mentioned Nuveen CEF. A low composite percentile means 1) long-term yields have recently risen and 2) muni CEFs are selling at steep discounts. The lower the composite percentile, the better for future muni CEF returns. No model is perfect, but forward 12-month returns have averaged +10-2 when the composite percentile is this low. Obviously this is just a historical average and has zero bearing on future subsequent returns. This return figure is a combination of muni bond interest income, CEF discounts shrinking, and the underlying bonds rising in value. Composite Percentile vs. Future 12M Muni CEF Performance 10 5 3 5 1-1 -3 2005 2008 Percentile Average (LHS) 2011 2014 Future 12M Performance (RHS)
WRAPPING UP The second half of 2016 has basically been a perfect storm for muni CEF investors. First, long-term yields spiked as investors raised their expectations of future inflation and demanded a higher yield from bonds, thus forcing down bond prices. Two, in September and October we saw an above-average amount of new muni bond supply hit the market. Three, short-term financing costs temporarily spiked for CEF issuers. This was a result of money market fund reform, where new regulation basically triggered a liquidation of short-term munis from money market funds. These short-term financing costs have since materially dropped. Pain could obviously continue for a few more months. But considering the previous composite percentile chart, it s clear to me that muni CEFs deserve a hard look right now. Let s wrap up with three different scenarios for a muni portfolio. A person s split between muni CEFs and a ladder of muni ETFs determines both the yield and volatility of their portfolio. An example muni ETF ladder could be staggered so that of the ladder expires in 2019, 2020, 2021, and 2022. It s basically a ladder of investment-grade munis maturing in 3-6 years. As these muni ETFs mature and are paid back at the end of each year, the proceeds can either be rolled back into the ladder or used for other purposes. There are two charts below. On the left, there are the portfolio yields of three different blend options. On the right, there s the annualized volatility of each of the three portfolios, plus the volatility of the S&P 500 and a 60/40 stock/bond split. This is meant to give you a reference for how volatile the muni portfolios have been. As you can see, a strategy 5 in muni CEFs and 5 in muni ETFs is less risky than a 60/40 portfolio, and also yields a net 3.6%. This alternative approach to munis is more diversified and liquid than holding individual issues until maturity, offers attractive yields, and can t be called away like individual bonds. 6. Net Portfolio Yield 4.8% 20. Annual Standard Deviation (Volatility) 18.9% 4. 2. 2.3% 3.6% 15. 10. 5. 7. 9.5% 11.6% 12.3% 0. CEFs ETFs 5 CEFs 5 ETFs CEFs ETFs 0. 25 CEFs 75 ETFs 50 CEFs 50 ETFs 60/40 75 CEFs 25 ETFs S&P 500
DISCLOSURES For the duration and yield chart, the four bond asset classes are represented by the following securities: muni bonds (NAD), high yield corporate bonds (HYG), investment grade corporate bonds (LQD), and long-term U.S. Treasuries (TLT). To calculate the after-tax yield, each fund s 30-day SEC yield was adjusted for a combined 4 tax rate. Percentile data was calculated internally by Movement. Muni ETF maturity chart is courtesy of Blackrock s ibonds ETFs: Fund Maturities Case Study document. Muni CEF market prices and NAV data is sourced from Yahoo Finance. All discount and return data shown is for NAD, one of the most liquid muni CEFs. Treasury bond yield data is courtesy of the St. Louis Federal Reserve Economic Database. Percentile data was calculated internally by Movement. Future twelve-month muni CEF returns are for NAD and were simulated and not realized in an actual client account. Portfolio yields are based on simulated blended hypothetical portfolios of muni bond CEFs and target date muni bond ETFs. CEFs are represented by NAD and target date muni bond ETFs are represented by a short-term 2-year muni ETF. Yields are pre-tax. Volatility information for a 60/40 portfolio is based on the annualized standard deviation of SPY and AGG. The S&P 500 is represented by SPY. MVMT Capital LLC ( Movement ) is a registered investment adviser located in Jackson, MS and is registered in the state of Mississippi. Movement may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. Movement s website and research notes are limited to the dissemination of general information pertaining to its advisory services. The publication of Movement s research notes should not be construed by any consumer and/or prospective client as Movement s solicitation to effect transactions in securities or as personalized investment advice. Movement does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party incorporated herein, and takes no responsibility. Movement's past performance and advice regarding client accounts cannot guarantee future results. As with all market investments, client investments can appreciate or depreciate. Investments involve risk and are not guaranteed.