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 that are trading at high discounts.
The iShares National Muni Bond ETF (MUB) fell by $0.31 and finished Friday’s session at $114.06 per share. The slight decrease of the benchmark of the municipal bonds came after the increased optimism around the partial trade deal between the U.S and China. The trade deal negotiations have been one of the main concerns of the market participants, and a possible solution will increase their desire for riskier assets. Of course, this will make safer assets such as municipal bonds less attractive for investors. However, nothing is final, and we are going to follow the situation and how it will impact the sector.
Source: Barchart.com – iShares National AMT-Free Muni Bond ETF
Of course, the changes in the Treasury yields are crucial for the performance of the municipal sector. The munis are interest rate-sensitive due to their higher duration, and most of the market participants pay serious attention to the fluctuation of the yields. The US 10-year Treasury yield bounced back from its bottom, as market participants again have an appetite for riskier assets.
Source: CNBC, US 10-Year yields
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 strong correlation between these major indices and the chart below proves it. Additionally, a statistical comparison is provided by our database software:
Source: Barchart.com – iShares 20+ Year Treasury Bond ETF
Source: Author’s software
Comparison Of The Yields And Municipal/Treasury Spread Ratio
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:
Source: Bloomberg, Municipal and Treasury Yields
Source: Bloomberg, Municipal and Treasury Yields
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.
Source: Bloomberg, Municipal and Treasury Yields
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.
Source: YCharts, 10-2 Year Treasury Yield Spread and 3-Month LIBOR based on US Dollar
Source: Yahoo News, Municipal Bond Closed-End Funds News
Several funds announced their regular dividends:
- DWS Strategic Municipal Income Trust (KSM) $0.0475 per share.
- DWS Municipal Income Trust (KTF) $0.0425 per share.
- Putnam Managed Municipal Income Trust (PMM) $0.0320 per share.
- Putnam Municipal Opportunities Trust (PMO) $0.0531 per share.
1. Biggest price decrease
2. Biggest price increase
Review Of Municipal Bond CEFs
1. Lowest Z-Score
The last month was extremely positive for most of the closed-end funds that invest in municipal bonds. The PIMCO New York Municipal Income Fund III (PYN) is the perfect example of what I am talking about. Over the past month, this CEF increased its price by 9.59% and was the best price performer. Just a month ago, this was the most undervalued fund in the sector from a statistical point of view, and I recommended to spend time on it and to decide if it is a good option for your portfolio. As you know, the Z-score shows us how many times the current discount/premium deviates from its mean for a specific period.
Indeed, we do not very often see PIMCO funds being traded at discount or with a negative Z-score. Currently, PYN is not even among the participants with the lowest Z-score, but its brother, the PIMCO New York Municipal Income Fund II (PNI), remains one of the interesting options from the area.
The BlackRock Maryland Municipal Bond Trust (BZM) reported another decrease in its statistical parameter after the announced dividend cut in July, and it is our weekly leader with a -1.00 Z-score. The management team decided to decrease the monthly distribution from $0.0474 per share to $0.0364 per share. The current yield which is offered by BZM is 3.09%.
2. Highest Z-Score
The recent interest rate cut is a positive fact for the prices of fixed-income assets with a relatively long duration. The municipal bond closed-end funds are exactly this type of asset, 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 that can help us to identify relatively expensive funds. From our perspective, a 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 95.5% of the time. So, when we see outliers, maybe there is a temporary mispricing.
KSM raises a red flag for me. The downtrend of its earning/coverage ratio is obvious, but the price continues on its way up. If the assets which are part of the portfolio do not start to bring higher profits, we can expect to see a dividend cut from the management team. No doubt, this will reflect on the price of KSM in a negative way.
The average one-year Z-score in the sector is 0.95 points. Last time, the average Z-score of the municipal sector was 0.99 points.
3. Biggest Discount
My recommendation here is to find a fund traded at an attractive discount and a relatively low Z-score. Depending on your investment horizon, take into account the average daily volume. If you are a trader, you do not want to include a liquidity risk to your plan. If you are a long-term investor, then the daily volume will not be so important, but then you need to gather more info about the portfolio.
The Neuberger Berman New York Intermediate Municipal Fund (NBO) is the fund that I am interested in. It has a discount of 12.48%, and currently, we do have a Z-score of 0.50 points. This closed-end fund seems undervalued compared to its New York peers.
On top of that, it has a positive earning/coverage ratio and positive UNII balance per share. The current yield offered by NBO is 3.80%.
4. Highest Premium
The funds plotted above are trading above their net asset value, which is a sign that we can find potential “Short” candidates. Ideally, our “Sells” should have a Z-score as high as possible. Here, from this observation, we have several closed-end funds with a premium that satisfies my requirements, but when we talk about PIMCO funds, I always say that we need at least a fundamental or very strong statistical reason to enter into a “Sell” position.
From my perspective, opening long positions in the BlackRock MuniAssets Fund (MUA) is not a good idea because the fund is trading close to its highest premium levels for the past decade.
The average discount/premium of the sector is -4.78%. Last time, the average spread between the prices and net asset values of the funds was -4.84%.
5. Highest 5-year Annualized Return On NAV
Above, we can see the willingness of the market participants to pay a premium for the PIMCO funds. This table could be a good explanation of that desire and why PIMCO funds are differently treated. The funds from this sponsor have proved that they can outperform their peers by return on net asset value over the past five years. The average return on net asset value for the past five years for the sector is 4.86%.
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 3.93%.
7. Lowest Effective Leverage %
The average effective leverage of the sector is 35.1%. 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 that you can review if you use the discount as a metric.
Note: This article was originally published on October 13, 2019, and some figures and charts may not be entirely up to date.
Trade With Beta
At Trade With Beta, we also pay close attention to closed-end funds and are always keeping an eye on them for directional and arbitrage opportunities created by market price deviations. As you can guess, timing is crucial in these kinds of trades; therefore, you are welcome to join us for early access and the discussions accompanying these kinds of trades.
Disclosure: 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.