VCV - VCV: Forward Outlook Suggests Value Remains

2023-03-20 06:21:06 ET

Summary

• I continue to see muni bonds as a preferred way to re-enter the fixed-income market, which has done much better in 2023.
• The fund's discount to NAV remains in double-digit territory. This offers inherent value for a stable sector.
• As expectations for the Fed's benchmark rate continue to decline in the wake of market volatility, more investors are going to want to lock in higher than average yields now.

Main Thesis & Background

The purpose of this article is to evaluate the Invesco California Value Municipal Income Trust ( VCV ) as an investment option at its current market price. The trust’s investment objective is to "provide current income exempt from federal and California income taxes".

This is a CEF I initiated coverage on with a buy rating last year and reiterated that stance going in to 2023. Looking back, VCV is up handsomely since I first covered it, although the gains have slowed down over the past three months:

Clearly the gains have slowed down. But I don't view this as a reason for exiting positions. Rather, I see it as a persistent value opportunity that readers can still take advantage of. I see a longer term bull story playing out for munis, especially for those in California who want tax-free income. I will use this review to explain why, and also why I see VCV as a good way to play it.

Munis Have Less Debt Outstanding Than Other Income Classes

As my followers know I am primarily an equity investor. But I do see the merit to owning some credit exposure, especially in municipal bonds and floating rate loans. I rarely dive in to the IG corporate bond markets or treasury markets for multiple reasons, one of which is that I generally see relative value in munis compared to those sectors. That after-tax yield tends to be higher (since I am a working professional) and I like the risk profile a bit better.

In 2023 this outlook remains largely intact. Yes, bond markets have been hit with more volatility than usual over the past year and a half. This is something difficult to contend with for more conservative investors and has plagued munis along with everything else. But one bright spot in relative terms is that munis continue to look like one of the safer plays to me. To understand why, consider issuance outstanding - which helps to gauge how likely future credit problems are going to be for the issuers. With respect to munis, debt outstanding has been fairly flat over the past decade. This is contrasted very sharply with the corporate and treasury sectors:

For me this gives continued support for why I want to own this sector at the expense of other fixed-income areas. I am a more conservative investor and munis seem to mirror that strategy better than other sectors given how much debt they have not piled on. While this in no way guarantees positive returns ahead, it does, at the very least, help me sleep better at night.

Investor Expectations Suggest Bonds To Be In Favor

Looking at fixed-income more broadly, I want to focus on why I think now is a good time to be buying-in. While I said I prefer munis already, this paragraph is relevant for most fixed-income asset plays. So for those who don't want California muni bonds through VCV - only maybe don't want munis at all - can still find this relevant for their other bond plays.

Specifically, I am referring to the recent turmoil in the banking sector, with the collapse for Silicon Valley Bank and Signature Bank, with perhaps others on the way. This is certainly not "good" for anybody - I am not about to suggest that. But it does open up opportunities in capital markets, so investors need to be aware of this. In particular it has sharply altered the outlook for the Fed's funds rate. While expectations are still that rates may go up in the immediate term, they are expected to start declining shortly thereafter. Not only that, but the pace of the decline is now expected to accelerate:

This is quite a shift in just a two week period. Markets no longer anticipate the Fed funds rate breaching the 5% level, and only see it sustaining above 4.5% for another few quarters. This is dramatic and could certainly change again in the months ahead. But for now, it opens up value in current yields within most fixed income markets. If one does believe this trend will play out, then locking in 4-5% yields in IG credit now makes a ton of sense. Personally, I think the Fed will pause at around the 5% level and then take a few months to reassess its impact, as well as the impact of recent bank failures on the broader sector and consumer confidence. While that plays out, quality bonds have a chance to rally. This is a buy sign for VCV, and many other options.

VCV's Valuation Still Piques Interest

Given VCV's 15% rise since I first covered it, one would think the valuation story was no longer as positive. This was a key metric I highlighted when I first suggested buying the fund and it has indeed performed well since that time. Still, I am very cautious with respect to entry positions for CEFs, primarily buying when they are at discounts and only slight premiums. Back in December, VCV still had a sharp discount, near 11% under NAV. This gave me confidence to keep the bull call in place.

Today, investors can still find similar value. At Friday's close, VCV offers new positions on the open market for just under 12% less than the fund's underlying value. That is a pretty good bargain:

Source: Invesco

The takeaway for me is very obvious. I view this large discount favorably and see it as a solid rationale to keep building my position. While VCV often has a discount, this is still quite wide and is at a level that I see narrowing in the year ahead. That makes me a continuous bull for now.

There Are Push-Pull Factors

So I see a number of tailwinds ahead for VCV. But that does not make this sector or fund risk-free. This is a very specific objective - California muni bonds. That lacks diversification inherently and exposes investors to unique risks. So understanding these risks is critical when deciding if this fund is really right for you.

One of these risks actually has to do with equity market volatility. This may seem counter-intuitive and to a degree it is. Hence why I call it a "push-pull" factor. What I mean is that on the one hand an increase in volatility within the stock market can be a benefit for muni bond funds like VCV. It can lead investors to want to take on less risk, look for stability, and collect income. So all of these work in the fund's favor. This is especially relevant since the S&P 500 has seen some big swings very recently:

So this could encourage muni buying - where's the push factor here?

The answer comes down to California's progressive tax structure compared to most of the country. While federal taxes and most states are progressive in nature, California is extremely reliant on income taxes for revenue. In particular the state has a high reliance on capital gains taxes, which expectedly go down during periods market drops. This has been the case for over the past year, putting a pinch on California disproportionately. Fortunately, the state went in to 2023 with a large cash reserve position to make up for the lack of capital gains taxes from the last fiscal year:

So that is the good news. But the bad news is that if the market stays down this year as well, that is going to prove a challenging backdrop since reserves can only make up for a lack of fresh tax dollars for so long. In short, while market volatility can be good for munis as a whole, it can have a negative impact on California's bonds in a disproportionate manner.

Another interesting development has been the decline in new issuance from the state. Over 2022, as interest rates rose, California dramatically cut back on bringing new muni bonds to market:

This is another mixed attribute. There is a check in the plus column in that it has helped keep outstanding supply of munis bonds low. This can increase the value of those bonds, all other things being equal. That is a positive for holders of VCV that own these bonds in the underlying portfolio.

The negative column gets a check because less new issuance means less cash on hand, all other things being equal. That means less flexibility for issuers and a higher likelihood of fiscal strain if challenging conditions persist. While I am confident in the long-term quality of these bonds, that does not mean they are fail-proof. So keeping a close watch on the state, and local issues liquidity, will be important in the year ahead.

Bottom-line

VCV has held up reasonably well and I expect continued modest gains going forward. The fund is filled with quality debt backed by a state with a large amount of cash reserves. While those reserves will be tapped in 2023, if we see an equity market rebound this year the coffers will be filled again. Further, the prospect for declining Fed rates in the quarters ahead provides a positive catalyst for fixed-income as a whole - including munis. Therefore, I believe a buy rating still makes sense for VCV, and I encourage readers to give this idea some thought at this time.

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