BBN - Municipal Closed-End Funds: Near-Term Pain Long-Term Gain?

2023-04-26 10:33:00 ET

Summary

• Municipal closed-end funds primarily invest in investment-grade municipal bonds with longer maturities to maximize tax-exempt income.
• Municipal CEF discounts typically widen in periods of market stress, but we believe this time may be different as credit remains on strong footing.
• Over the past year, the municipal bond market has seen increased volatility stemming from rising interest rates across the yield curve.

Key takeaways

• Municipal closed-end funds (“CEFs”) primarily invest in investment-grade municipal bonds with longer maturities to maximize tax-exempt income.
• Duration has had a negative impact on municipal CEF returns for the past 18 months and a flatter yield curve has caused leveraged funds to reduce distributions. ¹
• Municipal CEF discounts typically widen in periods of market stress, but we believe this time may be different as credit remains on strong footing.
• Municipal CEFs are now trading at some of their widest discount levels over the past 20 years.

Mixed feelings

Over the past year, the municipal bond market has seen increased volatility stemming from rising interest rates across the yield curve. This volatility has been magnified for Municipal CEFs, which primarily invest in long duration bonds and use leverage to maximize tax-exempt income. Following challenged performance in 2022 (down -24.4% on market price), municipal CEFs started the year strong, up 5.9% in January 2023, demonstrating how performance rebounded as interest rates fell and investor demand returned. We then saw a reversal in February 2023, given renewed investor fears of future rate hikes by the Fed. The volatility to start the year has been pronounced, and through March 2023, municipal CEFs are up 2.8% on market price for the year. ¹

To compound matters, the rapid increase in short-term rates, driven by one of the most aggressive Federal Reserve (“Fed”) tightening cycles on record, has resulted in a flatter yield curve and reduced the benefits of leverage, leading to lower fund earnings. This sparked distribution reductions across leveraged municipal CEFs and reduced investor demand for municipal CEFs. As a result, municipal CEFs saw increased selling pressure on the secondary market, causing the funds to move from a -1.5% discount at the start of 2022 to a -10.9% discount as of the end of March. For context on this change in premium/discount levels, municipal CEF valuations have been narrower 96%of the time over the last 20 years. ²

While municipal CEFs are trading at discounts levels similar to those of other periods of market stress such as the 2008 global financial crisis, we believe underlying municipal bond credit fundamentals remain strong. We believe long-term investors seeking attractive tax-exempt income may want to consider municipal CEFs, given their historically wide discounts. ²

All eyes on distributions

When evaluating municipal bonds, it is important to consider their tax equivalent yield ³ . Municipal bonds are exempt from federal taxes and investors can potentially receive additional tax benefits by purchasing state and local tax-exempt bonds issued by states and municipalities in which they reside. Municipal CEFs, which typically invest in longer maturity investment-grade bonds, are currently offering a median tax equivalent distribution rate of 6.9%, which is higher than the current distribution rate of individual municipal bonds (Exhibit 1). This is after many leveraged municipal CEFs have had to cut their distributions over the past year ⁴ .

Exhibit 1: Municipal CEFs can offer investors higher distributions

Tax equivalent rates for Munis

Municipal CEFs can deploy leverage by borrowing money at short-term interest rates, taking those proceeds, and investing in municipal bonds with longer maturities (and theoretically higher yields). In the current environment, a flatter yield curve (i.e., narrower spread) has negatively impacted the earnings of leveraged municipal CEFs. Over the long term, leverage has helped Muni CEFs pay higher distributions than other products (Exhibit 2).

Exhibit 2: Municipal CEFs may offer investors higher distributions

2018-2022 annual distributions of a hypothetical $1 million investment made every January 1st

Health check on municipal CEF distributions

Over the past year, leverage costs have increased sharply as the Fed has rapidly raised short-term interest rates by 5%. The SIFMA Municipal Swap Index, a common base rate used to calculate municipal CEF leverage costs, currently sits a 3.97%, which is 295 basis points higher than the 5-year average rate of 1.02% ⁵ . This increase has led to distribution reductions across the industry as fund earnings have declined. While the municipal yield curve rarely inverts and is not nearly as flat as the Treasury curve, this is a dynamic that investors should be aware of going forward. On a positive note, given their structural benefits (no inflows or outflows) , municipal CEFs may be able to “lock in” the higher yields we are seeing today, which could provide distribution stability going forward. We believe investors should regularly monitor municipal CEF distribution coverage ratios on a fund-by-fund basis. Many CEF issuers publish this data, including BlackRock, which publishes the data every month . This allows investors to see if the fund’s distribution is being “earned” in addition to the average cost of leverage for each fund.

Discounts: A long-term opportunity?

Municipal CEF premiums/ discounts have widened substantially over the last year given negative market sentiment as investors assess the impact of rising interest rates on municipal CEF performance and distributions. Municipal CEF premiums/discounts have widened by 480 basis points over the past year and 1,180 basis points from their 10-year high (narrowest) in 2021, and now trade at a median discount of -10.9% discount ⁶ . As mentioned earlier, municipal CEF valuations have been narrower 96%of the time over the last 20 years (exhibit 3).

Exhibit 3: Room to run? Municipal CEF have traded at wider discounts only 4% of the time over the past 20 years

Daily premium/discount observations for municipal CEFs over the last 20 years

We’ve seen this before

Investors buying municipal CEFs at abnormally large discounts caused by market stress may see strong relative returns during market rebounds (falling interest rates). As demand returns, discounts may narrow and may boost market price performance.

This dynamic has played out for municipal CEFs after sustained periods of negative performance. With history as a guide, we can see that Municipal CEFs tend to recover in the year following negative performance – in fact, the calendar year following a sell-off has produced a 16% return ⁷ on market price as investors took advantage of larger discounts and depressed asset prices (Exhibit 4).

Exhibit 4: The power of narrowing discounts

Muni CEFs market price returns (1997 – 2022) – 25 years

© 2023 BlackRock, Inc. All rights reserved.

¹ Source: Morningstar as of 3/31/23. Muni CEFs are represented by the Morningstar US CE Muni National Long category. Performance is based on market price. Returns and Premium/Discounts are based on category median. Morningstar US CE Muni National Long category was down -4.6% on market price in February 2023 and down -20.9% on market price over the past 18 months. Past performance is not indicative of future results.

² Source: Morningstar as of 12/31/22. Based on daily premium/discount data over the past 20 years. More details in Exhibit 3. Past performance is not indicative of future results. Morningstar category returns are shown for illustrative purposes only and are not meant to represent the past or future performance for any BlackRock fund.

³ Tax equivalent yield (“TEY”) is used by investors to compare yields on taxable and tax-exempt securities after accounting for taxes. TEY represents the yield a taxable bond would have to earn in order to match, after taxes, the yield available on a tax-exempt municipal bond.

⁴ Source: Morningstar as of 3/31/23.

⁵ Source: SIFMA as of 3/29/23. The SIFMA Municipal Swap Index is a 7-day high-grade market index comprised of tax-exempt Variable Rate Demand Obligations (VRDOs) with certain characteristics. The Index is calculated and published by Bloomberg. The Index is overseen by SIFMA’s Municipal Swap Index Committee.

⁶ Source: Morningstar as of 3/31/23. Muni CEFs are represented by the US CE Muni National Long category. Past performance is not indicative of future results. Morningstar category performance are shown for illustrative purposes only and are not meant to represent the past or future performance for any BlackRock fund.

⁷ Source: Bloomberg, Lipper as of 12/31/22. Muni CEFs are represented by the Lipper General & Insured Municipal (Leveraged) category. Past performance is not indicative of future results. Morningstar category performance are shown for illustrative purposes only and are not meant to represent the past or future performance for any BlackRock fund.

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Index Definitions:

S&P Municipal Bond Index: The S&P Municipal Bond Index is a broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market.

S&P U.S. Aggregate Bond Index : The S&P U.S. Aggregate Bond Index is designed to measure the performance of publicly issued U.S. dollar denominated investment-grade debt. The index is part of the S&P Aggregate ^TM Bond Index family and includes U.S. treasuries, quasi-governments, corporates, taxable municipal bonds, foreign agency, supranational, federal agency, and non-U.S. debentures, covered bonds, and residential mortgage pass-throughs.

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