PNF - DMB: Stay Far Away At This Stage Of The Cycle

Summary

• BNY Mellon Municipal Bond Infrastructure Fund recently cut its distribution.
• The fund has produced about 0% in total returns over the last 5 years as reversal from ZIRP had negative consequences.
• We look at the current setup and give you our outlook.

Municipal bonds are issued by state or local governments to finance their daily operations and capital projects such as building schools, roadways and other infrastructure. These capital projects could be on behalf of other entities such as colleges or hospitals. The bonds issued to finance the daily needs are called the general obligation bonds, and periodic payments to the bondholder are typically from the tax revenues. The bonds that finance the capital projects are called revenue bonds and these are repaid from the revenues earned from it on its completion such as toll charges. The interest income from both of these kinds is generally exempt from federal tax. Also, if one invests in a bond of their state of residence, the interest income is exempt from state and local taxes too. Unlike the top rating commanded by the big dog aka the federal government debt, the municipal offerings can be rated below investment grade. The rating depends on the financial strength of the issuer and/or the project being financed.

Our protagonist today, BNY Mellon Municipal Bond Infrastructure Fund ( DMB ) primarily invests in bonds issued to fund infrastructure projects. It also aims to have at least half of the portfolio in investment grade issuances. With an average effective maturity of over 18 years, DMB has not had an easy time since 2022.

Its yield did a good job of shielding the investors from a good amount of damage. Until recently the fund distributed 5.3 cents/month and that was cut down to 4 cents/month starting November 2022.

5-Year Returns

Over the last 5 years, DMB's total returns left a lot to be desired. Whether you looked at price or NAV, we got a rounding error in total returns.

Of course, DMB was hardly alone in this honor. As shown above, the category average was also in the same ballpark. Those poor returns are the direct consequence of the reversal from ZIRP (Zero Interest Rate Policy). This had the double whammy of normalization of interest rates and the complete collapse of the spread trade. All these funds engaged in borrowing pretty hefty amounts to fund distributions in an era of low rates. The juice had a price, and in many cases, the interest rates on short-term borrowings have risen way past the original coupons on these bonds.

Outlook

If you are buying the fund today, the first thing that you have in your favor is that it is trading at a discount. Investors might expect this (discount to NAV) to be a widespread phenomenon in this era of risk-free rates, giving you 5%. Unfortunately, yield chasing is not yet dead and investors are still bidding up funds. PIMCO Municipal Income Fund ( PMF ) and PIMCO New York Municipal Income Fund ( PNF ) are two shown as examples below where hope springs eternal.

The second thing is that bond pricing is a lot better today than it was a year back.

That is where your joy ends. The fund is still quite leveraged, with total assets 50% higher than total common assets. Most sites show the effective leverage by dividing the debt by the total assets.

That has an effect of making numbers look less scary for investors. We personally always see leverage relative to common assets. Whichever way you calculate it, keep in mind that there will be a good deal of gyrations coming from where interest rates and credit spreads go in 2023. We would also expect interest expenses to jump a lot in 2023. For the year ended on February 28, 2022, we saw interest expense of just 0.55%.

Look for this interest expense number to cross over 2% and bring total expense ratio to over 3%.

Those inverse floaters issued as debt will be powering this on full throttle, and there are some ways to go until the full impact is felt. This won't necessarily show up in the annual expense ratio released in 2023 as that is the average for the year. We are referring to the current and future run-rate, and that should be comfortably sailing past 3%. At this point, we would say that leverage is likely not adding any returns and definitely adding more risk here. Should we have more dislocations in the market, we will likely see some pressures on the lower tiers of its bond holdings.

Verdict

The fund had been a fan favorite for its "tax shield". The irony is that with a total return of about 0% over the last 5 years, you probably would not expect to pay any taxes anyway, now, would you? Of course, any other fund delivering this same type of total return (positive income and negative price changes) would have subjected you to some taxes. So there is that. You don't have to pay those taxes for DMB. Yea?

Today, the 4.24% yield likely translates into a 3.0%-3.5% total return in our view. Definitely better than the setup you had a year back. Also, definitely not worth it in our opinion. With so much leverage, a lot can go wrong. We would stick to non-leveraged funds at this stage of the cycle and look to get involved perhaps if we get a 20% discount to NAV.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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