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The Time To Hedge Is Now! February 2015 Update

Summary Brief overview of the series which began April 30, 2014. Why buy-and-hold investors should consider hedging. Current buy prices on some of my preferred put options. Discussion of the risks inherent to this strategy versus not being hedged. Back to January 2015 Update Strategy Overview If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this Instablog . In the Part I of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. Part II of the December explains how I have rolled my positions. I want to make it very clear that I am not predicting a market crash. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets. Why Hedge? With the current bull market having run more than 70 months, it is now more than double the average duration (30.7 months) of all bull markets since 1929. The current bull is now longer in duration than all but three bull markets during that time period (out of a total of 15). So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, and I will be the first to admit that I am probably earlier than I suggested at the beginning of this series. However, I do feel confident that the probability of experiencing another major bear market will rise in the coming year(s). It may be 2015, 2016 or even 2017, before we take another hit like we did in 2000-2002 or 2008-09. But I am not willing to risk losing 50 percent (or more) of my portfolio to save the less than two percent per year cost of a rolling insurance hedge. I am convinced that the longer the duration of the bull market lasts the worse the resulting bear market will be. I continue to base my expected hedge position returns on a market swoon on 30 percent, but now believe that the slide could be much worse as this bull continues to outlive its ancestry. Current Premiums on select Candidates In this section I will provide current quotes and other data points on selected candidates that pose an improved entry point from the last update. All quotes and information are based upon the close on Friday, January 30, 2015. I am calculating the possible gain percentage, total estimated dollar amount of hedge protection (Tot Est. $ Hedge) and the percent cost of portfolio using either the “Last Premium” amount shown or the middle of the range between the “bid” and “ask” premiums. The last premium paid on the last transaction of the day generally provides an accurate example of the cost and potential for each trade, except when the last premium is either at or beyond either the bid or ask premium. When the last premium is at or beyond either the bid or ask premium I chose to use the mid-point between the bid and ask premium. You may need to adjust your bid slightly higher if you do not get a fill, but a few pennies does not ruin the return potential on the suggested option contracts. Please remember that all calculations of the percent cost of portfolio are based upon a $100,000 equity portfolio. If you have an equity portfolio of $400,000 you will need to increase the number of contracts by a factor of four to gain adequate coverage. Also, the hedge amount provided is predicated upon a 30 percent drop in equities during an economic recession and owning eight hedge positions that provide protection that approximates $30,000 for each $100,000 of equities. So, you should pick eight candidates from the list and make sure that the hedge amounts total to about $30,000. Since each option represents 100 shares of the underlying stock, we cannot be extremely precise, but we can get very close. If the market drops by more than 30 percent I expect that we will do better than merely protect our portfolios because these stocks are very likely to fall further and faster than the overall market, especially in a crash. Another precaution: do not try to use this hedge strategy for the fixed income portion of your portfolio. If the total value of your portfolio is $400,000, but $100,000 of that is in bonds or preferred stocks, use this strategy to hedge against the remaining $300,000 of stocks held in the portfolio (assuming that stock is all that is left). This is also not meant to hedge against other assets such as real estate, collectibles or precious metals. Goodyear Tire & Rubber (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $24.24 $8.00 $15.00 $0.25 $0.55 $0.40 1650 $3,960 0.24% GT stock is actually slightly lower than it was at the time of the last update. But the potential gain is still good if you can get in near the latest premium paid. I don’t expect a major drop in share price without a recession, but we could see some gradual downside movement over the coming months. You will still need six January 2016 GT put option contracts to cover one eighth of a $100,000 equity portfolio. Williams-Sonoma (NYSE: WSM ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $78.25 $20.00 $55.00 $1.15 $1.60 $1.30 2592 $3,370 0.13% We need only one January 2016 WSM put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. The pricing in the January contracts has become more favorable. This is a good time to buy. In a recession, remodeling and painting projects get put on hold. United Continental Holdings (NYSE: UAL ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $69.37 $18.00 $35.00 $0.75 $1.26 $0.95 1627 $3,210 0.19% We need two January 2016 UAL put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. In the last update I used the June 2015 contracts; currently the January 2016 contracts are more cost effective than the June 2015 contracts. Travel is one of the first expense items to get cut by businesses during a recession. CarMax (NYSE: KMX ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $62.10 $16.00 $40.00 $0.90 $1.15 $1.00 2300 $4,600 0.20% We will need two January 2016 KMX put options with a strike of $40 to complete this position for each $100,000 in portfolio value. In the last update I used contracts with a $35 strike price, but the higher strike on these contracts will kick in sooner and afford us protection sooner in a downturn. The cost has gone up but the higher strike is worth it. Royal Caribbean Cruises (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $75.55 $22.00 $42.00 $1.04 $1.26 $1.10 1718 $3,780 0.22% We need two January 2016 RCL put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. RCL stock price has fallen since the last update but this candidate still offers a good return potential and should drop like a sinking ship during a recession. L Brands (NYSE: LB ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $84.63 $20.00 $56.50 $1.10 $1.25 $1.20 2942 $3,530 0.12% We need only one January 2016 LB put option to provide the indicated loss coverage for each $100,000 in portfolio value. Those of you who have been following the series will notice that I continue to increase the strike price from $50 to $56.50 to have our hedge protect us sooner. I do so whenever the option premiums allow us to do so at a reasonable cost. Marriott International (NASDAQ: MAR ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $74.50 $30.00 $50.00 $1.10 $1.25 $1.15 1639 $3,770 0.23% We need two January 2016 MAR put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Once again, business travel will suffer in a recession and MAR profits will be a victim. Tempur Sealy International (NYSE: TPX ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $55.03 $12.00 $35.00 $0.95 $2.10 $1.20 1817 $4,360 0.24% We will need two January 2016 TPX put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. TPX share price has rebounded bringing the stock back into the cross hairs for the strategy. Creation of new households will slow dramatically during a recession and the purchase of a new bed is something that gets put off until better economic times. I have chosen a premium price near the low end of the range but above the last premium paid price of $1.14. Micron Technology (NASDAQ: MU ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.27 $10.00 $19.00 $0.25 $0.29 $0.27 3233 $3,492 0.11% We need four July 2015 MU put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. I switched from the January 2016 contracts because the July has become more cost effective at a higher strike. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $33.81 $15.00 $27.00 $0.47 $0.55 $0.50 2300 $3,450 0.15% We need three July 2015 MS put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. MS seems to me to be one of the more susceptible of the big banks in a downturn. Recessions usually do not treat the financial sector well and MS has a history that makes it a favorable candidate. Seagate Technology (NASDAQ: STX ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $56.44 $24.00 $40.00 $0.40 $0.48 $0.45 3456 $3,110 0.09% We will need a total of two June 2015 STX put options with a strike of $40 to complete this position at current pricing levels for each $100,000 in portfolio value. In an unusual move I dropped the strike price from $45 to $40 because the cost had gotten too high on the $45 strike contract. Having said that, there are more efficient options listed above so I would be inclined to wait on this one for better pricing. E*Trade Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $23.05 $7.00 $20.00 $0.82 $1.03 $0.90 1344 $3,630 0.27% The position shown above would require three July 2015 ETFC put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Remember that these options expire in July 2015 and will require us to replace them at additional cost if the bull market is sustained. The cost has come down enough to put this candidate in play for the strategy. Yet there are better choices so I will wait a little longer for better pricing or use another candidate for my hedge. Sotheby’s (NYSE: BID ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $42.55 $16.00 $30.00 $0.40 $0.80 $0.70 1900 $3,990 0.21% We would need three July 2015 BID put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. This candidate stock has risen enough to provide a reasonable return. BID is really a play on the slowing of the Chinese economy, and specifically on the falling real estate prices. As newfound wealth created from overbuilding begins to deteriorate, purchases of art and collectibles loses its glamour. BID always seems to fall precipitously when there is a global recession. Level 3 Communications (NYSE: LVLT ) option costs have risen and are too high to be considered at this time. If the situation changes I will include the candidate in a future update. Summary My top eight choices from the list above includes LB, KMX, GT, WSM, MAR, RCL, TPX and UAL. That group (using the put option contracts suggested above) should provide approximately $30,580 in downside protection against a 30 percent market correction at a cost of 1.57 percent of a $100,000 portfolio. None of the candidates will need to be replaced until next January thereby keeping the cost below two percent for nearly a year. Brief Discussion of Risks If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our new option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration beyond January 2016, using from up to three percent of my portfolio to hedge for another year. The longer the bull maintains control of the market the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins early in 2015; but if the bull can sustain itself into late 2015 or beyond, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I either hold put options in the stocks listed or will be buying them in the next week.

What Are The Limitations And Consequences Of ETFs?

By Niall H. O’Malley of Blue Point Investment Management Before delving into the limitations and unintended consequences of Exchange-Traded Funds (ETFs) it is important to define an ETF. Where did these investment vehicles originate? How significant are ETFs to investors? The first Exchange Traded Fund was launched in January 1993 by State Street Global Advisors under the ticker symbol (NYSEARCA: SPY ). The ETF was designed to track the value of the S&P 500 Index. It is quoted at 1/10 of the value of the S&P 500. The ETF was marketed as a “spider”, shorthand for Standard & Poor’s Depository Receipt (SPDR), traded on the New York Stock Exchange. The popularity of the S&P 500 SPDR led to a family of products. Other fund management companies, such as Barclays – creator of iShares – and Vanguard, followed suit in short order and the universe of ETFs rapidly expanded. The S&P 500 SPDR is still one of the most popular ETFs. Its average volume exceeds 110 million shares on a daily basis, and its assets under management are over $171 billion. 1 How Significant are Exchange Traded Funds and Related Exchange Traded Products? As a financial innovation that is approaching its 22nd anniversary, it is fair to say Exchange Traded Funds and the related Exchange Traded Products have been revolutionary. Investors have entrusted over $2 trillion to this financial innovation. ETFs have grown in popularity since they offer investors cost effective diversification to markets, sectors, currencies and commodities. ETFs have evolved into a family of closely related investment vehicles known as Exchange Traded Products (ETPs). ETPs include Exchange Traded Notes, Leveraged ETFs, Inverse ETFs, Exchange Traded Commodity Pools, Exchange Traded Vehicles (ETV) and Active ETFs. The success of ETFs and other Exchange Traded Products is quite striking, especially when one considers the number of companies traded on the New York Stock Exchange and the NASDAQ, 6,251 2 , compared to the number of global ETFs and ETPs, 5,463. Most ETFs and ETPs are traded in the U.S. There are 1,686 ETFs and ETPs that invest in just U.S. securities and 3,777 that invest in varying levels of international securities. Over 95% of the ETFs and ETPs are passively managed. Once the exchange traded basket is established the composition of the ETP is on autopilot, i.e. it is not actively managed. Note: Exchange Traded Products is often used as an umbrella term. In the chart above Exchange Traded Funds growth is detailed in the top line and growth in other exchange traded structures is detailed in the bottom line. What Are Some of the Benefits of ETFs? Cost Effective Diversification The primary strength of Exchange Traded Funds is the cost effective passive diversification they offer an investor. As an example, exposure to the S&P 500 Index can be gained through the purchase on one share of the S&P 500 SPDR ETF rather than purchasing 500 separate securities. The expense ratio for the S&P 500 SPDR is 0.09% which is very low. The average institutional ETF expense ratio is 0.562%. ETF holdings vary widely from less than 10 securities to over 16,000 securities. An ETF, like a mutual fund, pools the assets of multiple investors; however, ETFs tend to be significantly less expensive and offer instantaneous pricing information during the trading day rather than once daily pricing as is the case with mutual funds. Each share in an ETF represents an undivided interest in the underlying securities less the expense ratio. To understand the pricing variations, an investor has to factor in the type of ETF. An additional consideration with mutual funds is the share class and whether a sales fee is taken. When considering mutual funds, the investor also needs to factor in the fee structure. The table below provides insight into the expense ratio variations in open end funds. Both mutual funds and ETFs are considered open-end funds, i.e. there is no limitation on the number of shares that they can issue. You will notice in the table below that passive ETFs do not have mutual fund sales commissions referred to as front-end load/ No load and back-end load/ level load. Deep Liquidity for Popular ETFs The larger ETFs offer deep liquidity, e.g. the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) – founded by Barclays and now managed by BlackRock – has an average daily volume that exceeds 60 million shares and assets under management exceed $36 billion. However, not all ETFs are highly liquid. In fact, liquidity varies widely among ETFs. Important liquidity considerations are the average trading volume, assets under management, plus the strength of the counterparties – authorized participants – that create and redeem the ETF shares. Another consideration is the complexity of the ETF in terms of the number of securities held. Each security is dependent on a functioning market for price discovery which can be interrupted by trading halts and “flash crashes”. New Investment Approaches Investors, both individual and institutional, can use ETFs to gain rapid, cost effective diversification to markets, sectors and various strategies, e.g. growth and/or value. The explosion of the ETF universe has expanded the toolset available to investors. A popular investment approach is a combination of active and passive investing. Investors may also take an active management approach incorporating individual securities or actively managed funds. This is referred to as “seeking alpha”. The investor is seeking a return above the market return represented by market indexes. Some investors prefer to pursue a purely passive approach with ETFs and ETPs which limits down side risk offering a weighted average return. What are Some Limitations and Unintended Consequences of ETFs? Short-term Trading, Taxes and Lower Realized Price Perhaps the biggest ETF limitation is behavioral. ETFs are credited with being less work. All an investor has to do is buy the basket of securities represented by an ETF and the benefits of diversification are gained. While it is true that ETF investing involves less work, it creates an unintended consequence of creating less conviction in the face of adversity – a market selloff. This increases the chance that the investor will become more reactive and short-term oriented. For taxable investors, this introduces the higher short-term capital gains rate. It is important to note that taxes are not the only cost. A potentially even greater cost is incurred when an investor sells during a market selloff and realizes a loss. Performance Limitation – The Best Return is an Average/Weighted Average Return If you had a child, would you encourage them to get Cs in school? The frequent encouragement from parents is to seek As and Bs. Why does the same rule not apply to your investments? How often does an index double? The answer is not that often. When an investor invests in an ETF, it is important to realize that they are electing to receive an average return for the invested amount. An average grade in school is a C. The return of an ETF is the weighted average of the underlying securities less the expense ratio. In short, while the ETF assets benefit from diversification there is a performance limitation. A Less Transparent Issue – Tracking Error & Counterparty Risk An ETF’s market price can trade at a premium or a discount to the value of its underlying securities. Wider bid/ask spreads occur when an ETF or security is thinly traded which creates additional investment costs. The creation and redemption of ETF units is dependent on counter parties that are referred to as authorized participants. An ETF fund manager enters into contractual relationships with one or more authorized participants. Authorized participants create ETF fund shares in large increments – typically 50,000 fund shares. The authorized participant or participants seek to minimize pricing differences between the market value of underlying ETF securities and the net asset value of the ETF. Authorized participants seek to arbitrage the pricing differences but are dependent on functioning markets and stability of their broker dealer operations. Flash crashes and other market disruptions associated with high frequency trading arbitrage can create tracking error. Structure Risk As the popularity of ETFs has grown, it has given way to an alphabet soup of Exchange Traded Products which include alternative ETFs, Exchange Traded Notes (ETNs), alternative ETFs, exchange traded vehicles (ETVs), exchange traded commodities or currencies (ETCs), and other types of structures. It is important to note that the product structures of the newer ETPs in turn create unique risks for investors. From a structure and regulatory perspective, ETFs are open-ended investment companies that offer investors an undivided interest in the underlying securities of the fund less expenses. The same is not true with Exchange Traded Notes (ETNs). An an ETN is just a credit obligation from the issuer, i.e. there is no collateral. The credit obligation is only as good as the balance sheet of the issuer. This became a painful lesson for investors in the Lehman Brothers ETN products as they did not own the underlying collateral, and therefore, became unsecured creditors in the Lehman bankruptcy. Alternative ETFs give investors the potential to invest in investment options that are leveraged and/or inversely correlated to its index benchmark. Typically, alternative ETFs are designed to generate daily returns that are a positive or negative multiple of its benchmark, e.g. stock indexes, currencies and commodities. The math of daily settlements introduces the risk of significant tracking error, and introduces a tax liability that does not exist with traditional ETFs. The primary collateral for alternative ETFs are the derivative contracts and money market instruments used to create the leveraged or inverse exposure. Local Firm Participation A Bethesda, Maryland firm, ProShares, is the world’s largest provider of leveraged and inverse ETFs. ProShares has grown from one fund in 2006 to over 145 alternative ETFs. Another Bethesda, Maryland, based firm is AdvisorShares which offers 28 actively managed ETFs. Actively managed ETFs were first approved by the Securities and Exchange Commission in 2008. The actively managed ETF adds an active management component to the ETF structure that has otherwise been passively managed. T. Rowe Price has received regulatory approval to issue actively managed ETFs. Legg Mason has also received approval from the Securities and Exchange Commission to begin issuing actively managed ETFs. Investment Considerations Before making any investment, it is important to identify your goals and understand the limitations and opportunities associated with the investment you are considering. Do you want the weighted average return? Faced with a market selloff do you have conviction about your investment? Are you familiar with the fund manager? What is the underlying collateral? Exchange Traded Funds and Products have expanded the investable universe for investors. One of the most important benefits that ETFs and ETPs offer is their ability to diversify a portfolio. This is especially true in emerging and developing markets where investment options may not otherwise be accessible. Whether investing in an ETP or a listed company, it is important to research your investment. Due diligence is a key consideration that should not be overlooked whether investing passively, actively or in a blended approach. Sources: – https://www.spdru.com/?internalR edirect=https%3A%2F%2Fwww. spdru.com%2F&_new_user=1#/ content/debunking-myths-and-common-misconceptions-of-etfs – https://www.spdru.com/?internalR edirect=https%3A%2F%2Fwww. spdru.com%2F&_new_user=1#/ content/9-questions-every-etf-investor-should-ask-before-investing – https://www.fidelity.com/learningcenter/investment-products/etf/ drawbacks-of-etfs – http://www.forbes.com/sites/ rickferri/2013/09/02/etf-fees-creephigher/ – https://www.fidelity.com/ viewpoints/active-trader/no-stopping-ETFs – http://www1.nyse.com/about/listed/ nya_characteristics.shtml – http://www.lipperweb.com/ Research/Fiduciary.aspx – http://etfdb.com/compare/marketcap/ – http://www.ici.org/pdf/per20-02.pdf – http://www.etfgi.com/index/cookie Endnotes : 1 ETF Database Top 100 ETFs by Assets 10/16/14 NYSE 3,296 and NASDAQ 2,955 as of 10/16/14 2 ETFs 3,868 and 1,595 ETPs

There Are Few Bargains In Tax-Free Income… Here’s 3

Summary Municipal bonds are coming off one of their best years in a long time. Most municipal bond, closed-end funds are selling well above their usual discount/premium status, a situation nearly exactly opposite that of a few months past. In this article I consider three funds that still present attractive valuations and propose one as my top choice. Few Bargains in Tax-Free Income. Here’s Three. After a dismal 2013, municipal-bond closed-end funds turned in a strong showing in 2014. Let’s start by looking at the largest and most liquid municipal bond ETF as a benchmark. iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) is up 5.42% for the past 12 months and has a 12 month tax-free yield of 2.74%. Not bad for muni bonds, but it doesn’t sound all that terrific, does it? Now, compare that to the median national municipal-bond closed-end fund: 12 month price return of 17.09% coupled with a current, tax-free yield of 5.87%. That’s a total return difference of nearly three fold. How is it that closed-end funds outperformed the benchmark ETF to such an extent? First is their use of leverage: the median muni-bond CEF is leveraged at 34.9%. This can provide a substantial boost in a year such as 2014 but will, of course, drag a fund’s performance down in a less favorable year such as 2013. A second factor is credit quality. Many CEFs will delve more deeply into the credit risk pool than MUB which holds 83% of its portfolio in bonds rated A and above compared to the category average of 74%. Here again, when things go well taking on credit risk can pay off. But in 2013 exaggerated fears of credit risk, driven largely by sentsationalist media coverage of the municipal bond market, proved costly to investors in this asset class. Finally, there’s the factor unique to CEFs: most sell at a discount to their NAVs. This cuts two ways: A discount pumps up the yield on NAV; buying a fund that pays, say, 6% on NAV at a 10% discount turns that 6% into 6.67% at market price. Plus, if a discount compresses, the holder of the fund enjoys capital appreciation unrelated to the price movements of the underlying assets. The first two factors, leverage and portfolio quality, tend to be stable for any given fund. The third, premium/discount status, tends to be quite volatile for municipal bond CEFs, and will often offer attractive buying opportunities. The strong showing for municipal bond CEFs over the last year, and the past few months in particular, has been driven in considerable part by discount compression. This has left few bargains for the tax-free income shopper. The median discount for national municipal-bond CEFs stands at -6.81%. Nearly -7% may look good at first glance but it compares poorly with recent history for the category. How poorly? That -6.81% is more than 2 standard deviations higher (i.e. less discounted) than the median discounts of 3 or 6 months ago. Such numbers do not offer much of an attractive market for buyers. Recent Changes in Premium/Discount Status in Municipal Bond CEFs The metric used to measure how a closed-end fund’s current premium/discount relates to its recent history is the Z-score which indicates how far from the average discount or premium a fund’s current discount or premium is. A fund with a positive Z-score is currently trading at discount or premium higher than its average. Negative Z-scores indicate distance below the average (deeper discounts). Only 4 months ago, when I last wrote about muni-bond CEFs, negative Z-scores were overwhelmingly the rule. That’s now turned around completely with the median Z-scores for 3, 6 and 12 months standing at 2.26, 2.17 and 0.97, respectively. This chart shows distributions of Z-scores for 3 and 6 month periods for 99 national municipal-bond closed-end funds. To see mean reversion in action, it’s worth comparing these to charts of the same metric in Figure 2 from October 2014 which present nearly exact mirror images of these charts in shape if not scale. Figure 1. Z-score distributions for national municipal-bond closed-end funds. In the entire universe of municipal-bond closed-end funds 5% have discounts deeper than their average for the last 3 months and only 8% for the 6 month average. A Moderate Fund-Trading Strategy for Muni-Bond CEFs That Combines Tax-Free Income and Periodic Capital Profits I consider closed-end funds to provide the best choice for exposure to tax-free income. I would argue that the municipal bond arena is the space where CEFs are the clear investment option of choice. They return consistently high-distribution yields on an absolute measure, and very high yields on a tax-adjusted basis in an investment category typified by low yield for essentially every other investment vehicle. Because CEFs often use high leverage and credit-risk as mechanisms to achieve those high returns they tend to be riskier alternatives in comparison with municipal-bond ETFs or holding individual bonds. To moderate some of that risk, I buy muni-bond closed-end funds when they are priced attractively relative to their typical discounts/premiums. To this end I rely on Z-scores to provide a measure of that relationship. I base this on an assumption that the funds with outsized Z-scores will tend to revert to their means over time. Some readers object to this emphasis on Z-scores, which I can appreciate. For the buy-and-hold investor they may be a relatively minor factor in an investment decision. But, I have been able to identify appealing opportunities by including this metric along with the more important considerations of yield and portfolio quality. Understand, as well, that I am always prepared to trade out of a fund if that carefully selected extreme discount reverts to the fund’s less deeply discounted mean, which is, in fact, what I expect to happen most of the time. An investor less inclined to trade funds will, of course, be less inclined to value this metric. Over the past few years I have purchased funds at outsized discounts and sold them at a profit as they reverted to something closer to their mean discounts, using the proceeds to purchase other funds with attractive entry points. With about 100 national muni-bond CEFs and another couple of dozen funds from my home state of California to select from there is always a lot of choice. This approach has provided steady, tax-free income in the 6 to 7% range and modest profits as I traded into new funds. By following this strategy, I presently hold muni-bond funds purchased when they had deeply negative Z-scores. Riding the rising tide in the asset class, they have logged substantial capital appreciation, a fair portion of which is attributable to mean reversion of their discounts. In fact they presently have Z-scores well over 2, so I would like to trade out of them and capture those profits. But there are precious few funds that meet the standards I’m looking for in a replacement. Screen Criteria and Results Can we find some reasonable buys in spite of the clear lack of the sorts of bargains that were available in the recent past? To find out, I downloaded the full list of national muni-bond CEFs from cefanlayzer.com and screened them using the following criteria: Market price yield at or above the median of 5.87%. Discount at or below the median of -6.81%. Z-score for 1, 6 and 12 months being negative for at least 2 of the 3 periods. These are pretty open filters. A few months ago they would have returned dozens of selections to explore. Today the screen passed only two funds: BlackRock Strategic Municipal Trust (NYSE: BSD ) and Dreyfus Strategic Municipal Bond Fund (NYSE: DSM ). With so few candidates, I opened the filter a bit more, stretching the market-price yield down to 5.80%, a bit below the median yield of 5.87%. This added a third candidate, Eaton Vance Municipal Bond Fund II (NYSEMKT: EIV ). This table summarizes yield on market-price, discount and Z-score values for the three funds. Figure 2. Yield, Discount and Z-Scores (Source: cefanlayzer.com ). When I write about tax-free municipal bond funds I like to show the equivalent tax-free yields for investors at a range of marginal tax rates, which I feel gives a better sense of how appropriate a yield point may be in for any individual’s case. Here’s the table. Figure 3. Taxable equivalents for Federal Marginal Tax Rates. As you can see, for an investor in the mid to upper tax brackets, the CEFs are providing extremely attractive tax-adjusted yields compared to what’s available in today’s fixed-income environment. Even at the lowest tax brackets one would be hard pressed to find fixed-income investments with comparable yield and safety. The Funds This next table summarizes some key features of each of the three closed-end funds under consideration. Figure 4. Leverage, Maturity, Duration, Credit Quality and Morningstar Ratings (Sources: cefanalyzer.com and Morningstar). BlackRock Strategic Municipal Trust has been selling at a discount between -4 and -8% since mid-2013. It’s current discount reflects a move upward from a low of -9.84% in August 2014. Distributions are paid monthly and have been steady at $0.074/share since 2010. The fund has not paid out return of capital since its inception. The top 5 states represented are Texas (13.3%), Illinois (11.2%), New York (9.2%), California (8.7%), New Jersey (6.1%). Tobacco bonds, generally considered the riskiest of muni bond categories, are not included in the top 5 sectors held in the portfolio. Morningstar rates the fund as having high to above average risk. The fund has a Sharpe ratio of 1.63 relative to the benchmark Barclays Index of 1.14. Dreyfus Strategic Municipal Bond Fund has been selling at a discount near -5% since early in 2013. Its present discount of -6.8% is marginally lower than its recent history and a full standard deviation below its one year average discount. Distributions are paid monthly. They were cut from $0.0475 to $0.0415/share in November 2014. The fund does not pay any return of capital in its distributions. Top five states are Texas (15.2%), California (12.6%), New York (11.8%), Massachusetts (8.1%), and Arizona ((4.5%). Morningstar rates the fund as having average risk. The fund’s Sharpe ratio is 1.09 relative to the benchmark’s 1.14. Some might express concern about the lead role of Texas in these two portfolios in light of the possible negative impacts of the oil crash on local municipal revenues. It’s just about impossible to sort out how much or little of a factor this may be. My inclination is to dismiss this as an immediate worry. Municipal bond default rates are so low relative to essentially all other bond categories, that I consider this risk exceptionally low on the list of possible risks for the funds. Eaton Vance Municipal Bond Fund II is the final of the three funds. It has seen its discount move to -8.1% at present which is above the -9% range it fell to during November and December 2014. Otherwise it’s about as low as it has been since late 2013. This is just short of one standard deviation below its 12 month average discount. The fund’s monthly $0.0631/share distribution has held steady since a drop in 2012. The fund does not pay return of capital in its distributions. The top holdings in the portfolio comprise bonds from New York (10.3%), Florida (7.5%), Pennsylvania (7.5%), New Jersey (7.1%) and Massachusetts (5.8%). Morningstar rates the fund as having above average risk metrics. Its Sharpe ratio is 1.21 compared to the benchmark’s 1.14. Most notable about EIV is that it has excellent credit quality. Recall that the category average for bonds rated A and above is 74% and for MUB, the benchmark ETF, it’s 83%. Compare EIV: With 92% of its bond portfolio rated A or better, credit risk becomes a near insignificant factor. Finally, EIV outperformed its category in 2014 on a NAV and market price basis despite having not suffered the significant discount compression along the way that its peer funds did. Summary and My Top Choice Any of the three I’ve listed here are, in my view, worthy of a hard, close look for those exploring an investment in tax-free high-yield. My top choice would be the Eaton Vance offering, EIV, but my enthusiasm for it as top choice is somewhat tempered. On the plus side is its portfolio characteristics (credit quality, maturity and duration) which are clearly the best of the three. At