NZF - Muni CEF Update: Great Time To Buy But Not Without Challenges

Summary

• What a difference a year makes - a year ago Muni bond yields were barely above 1% while Muni CEF discounts were close to zero.
• This time around both bond yields and CEF discounts are at very attractive levels.
• At the same time, the sector faces two challenges which we discuss in this article.
• We continue to see value in funds like BTT, NAD and NZF.

This article was first released to Systematic Income subscribers and free trials on Jan. 23 .

In this article we provide an update on the tax-exempt Municipal CEF (closed-end fund) sector. Our main takeaway is that today is a very attractive environment to add to Muni funds, both in terms of underlying yields and discounts. However, a strong investment environment like the one we have today for Municipal bonds is not without its own challenges, two of which we highlight below. We also highlight a number of funds that we find attractive.

A Strong Investment Environment

One way we like to think about CEF valuations is in a two-dimensional grid of underlying yields and discounts. The chart below plots tax-exempt yields (x-axis) and tax-exempt CEF sector discount (y-axis). Periods of wide discounts and high yields (i.e., in the bottom right) are more attractive than periods of tight discounts and low yields (i.e., top left).

Today's environment is not as attractive as was the case in late 2022, when discounts were about as wide as they are now but underlying yields were higher by almost 1%. However, it's much better than the situation we had in 2021 where most of the monthly readings were in the expensive top-left quadrant.

This valuation picture suggests that today is a good environment for allocating to tax-exempt CEFs. The pain that many holders of the sector experienced in the past year is simply due to this valuation combination moving from the top-left part of the matrix to the bottom-right.

Challenge #1 - Long Wait Till Higher Distributions

While many Muni CEFs are still busy cutting distributions, many investors are looking at higher bond yields and beginning to wonder when CEFs will be able to take advantage of these higher yields and pass them back to investors in the form of higher distributions.

To simplify things, let’s imagine a CEF holding one bond. The rise in market yields has no impact on the fund’s cashflows until the maturity / redemption / sale of the bond given its fixed coupon. When the bond is redeemed, then the principal can be reinvested into new bonds. It is only then that the fund has the chance to increase its distributions. To generalize a bit, the way this might work is, let’s say, a high-yield corporate bond fund bought a 5-year 5%-coupon corporate bond at the start of 2022 at par (HY corporate yields were around 5% back then). When the bond matures at par in 4 years the principal can be reinvested into a new bond at its prevailing yield. Corporate bonds tend to be issued with coupons in line with their yields so, again, to keep things simple we can assume the fund can buy a bond with the coupon roughly matching its yield for the price of around par.

Of course, the fund doesn’t really need to wait for the 5% bond to mature. If it wanted to grow its income today it can start to rotate into higher-coupon bonds. This is an explicit strategy that a number of funds follow. This is always possible and there is no need to wait for a maturity. For Munis, the situation is a little different. Muni bonds tend to be issued at similar coupons of 4-5% regardless of their yields. So, the corresponding increase for Muni CEFs will be lower because coupons won’t increase for new Muni bonds. Rather, prices at issuance won’t be $120 but more like $100 to reflect higher Muni yields than we had a year ago.

So rather than the 60% income increase for HY bonds on the reinvestment of capital, the increase will be more like 20% for Munis. In other words, instead of the fund buying an 8% bond at par rather than a 5% bond at par, the Muni fund will buy the new 5% bond at $100 rather than at $120.

Another issue for Muni CEFs is that Muni bond maturities are quite long. Bonds tend to be callable and historically they have been redeemed at around 5 years into their life. The risk here is that a lot of these bonds will not be redeemed as many are trading below par. In short, the wait for old bonds to mature can be significantly longer for Muni funds than in other credit sectors and this may also limit how much Muni CEF distributions can increase.

In short, Muni CEF distributions are going to increase eventually, but the wait and the size of the increase is likely to be longer and smaller than for corporate bonds funds.

Challenge #2 - Little Yield Generation Via Leverage

The rise in short-term rates over 2022 has significantly increased the cost of leverage of most CEFs. This is because most CEFs have floating-rate leverage instruments such as repo, credit facilities and other instruments. Some funds have a portion of their leverage cost in fixed-rate instruments or partial hedges in place, but it's a rare CEF that has fully fixed their leverage costs for more than a few months.

Municipal CEFs use floating-rate leverage instruments such as variable-rate preferreds and tender option bonds. This means their leverage cost has increased last year. The chart below shows what this looks like for the large Nuveen fund ( NAD ).

Leverage cost is just one aspect of net income. Some funds, primarily those with floating-rate assets, can carry floating-rate leverage facilities but still increase their net income for the simple reason that they have a much larger asset base than leverage instruments (a typical leveraged CEF with $150 of assets has $50 of leverage instruments i.e. a leverage of about 30%).

There are three aspects of Municipal bonds that create a challenge in the current environment with respect to net income.

First, Municipal CEFs have fixed-rate assets and floating-rate leverage instruments with no hedges. This means that they are more impacted by rising leverage costs than funds with either floating-rate assets or funds with hedges in place.

Secondly, the flattening of the yield curve over 2022 has further decreased the additional yield that is generated via leverage. Granted, the situation in the tax-exempt space is not as bad as in the taxable space as the tax-exempt yield curve is not yet inverted.

Thirdly, tax-exempt bonds are relatively high quality within the overall bond market. This means that the additional credit spread earned via leverage is low.

To give an example for a fund like NAD, the fund has leverage cost of 3.41% as of November (and higher now) and a management fee of 0.59%, totaling 4% while the yield on its assets is around 4.10%. What this means is that the fund earned around 0.10% on its leveraged assets (4.10% - 0.59% - 3.41%).

For perspective, the fund carries $3bn of assets sourced with equity capital and another $2.1bn of assets sourced via leverage. In other words, for $3 of unleveraged assets (on which it earns 4.1% - 0.59% = 3.51%), it has $2 of leveraged assets (on which it earns 4.1% - 0.59% - 3.41% = 0.10%). In other words, 40% of the fund's assets generate only about 0.10% in yield.

The fact that Muni CEFs earn very little on leveraged assets is not in itself a deal-breaker. Muni CEFs provide leveraged exposure to Muni bonds which magnifies returns in case of a rally such as the one we have seen recently as tax-exempt yields have fallen. Investors can also mitigate the low yield on leveraged assets by allocating to high-yield and unrated bonds which tend to trade at higher yields.

Stance And Takeaways

Despite the recent rally as well as the challenges outlined above, the Municipal tax-exempt sector remains attractive on a number of fronts: high after-tax yields, wide CEF discounts, strong fundamentals and more.

We continue to see value in a number of CEFs.

This includes the BlackRock Municipal 2030 Target Term Trust ( BTT ), trading at a 7.8% discount (vs. 7.6% sector average) and a 3.06% current yield (vs. 4.5% sector average). The fund has a modest duration and a term structure which provides a potential discount compression tailwind in case of termination. The fund has cut its distribution by "only" 10% over the past year versus figures of 30-40% for many popular funds. BTT is one of the best-performing funds over the past year as well as over the last 5 years in total NAV terms.

We also like the stalwart Nuveen Quality Municipal Income Fund ( NAD ), trading at a 10.7% discount and a 3.95% current yield. The fund has done a better job of managing its leverage profile than its PIMCO counterparts which has supported its long-term returns.

Finally, we highlight the Nuveen Municipal Credit Income Fund ( NZF ), trading at a 10.3% discount and a 4.1% current yield. NZF has a higher-yield profile which allows it to generate more yield overall as well as on its leveraged assets. NZF has outperformed the sector by 0.7% per annum over the last 5 year in total NAV terms. It also trades at an attractive valuation - with a discount 4% wider of the sector average.

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