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Tax-Free Income From Municipal-Bond CEFs: A Closer Look

Summary Municipal-bond closed-end funds offer excellent opportunities for high levels of tax-free income. This category is the largest in the closed-end fund space. Here I look in some detail at funds that rose to the top in an earlier filtering of the entire municipal bond CEF universse. A Closer Look at Top-Scoring Municipal Bond CEFs I recently discussed tax-free, municipal-bond, closed-end funds ( here ). Tax-free munis comprise the largest category of closed-end funds. Two sites ( Cefanalyzer and cefconnect ) were the primary sources for the previous report. They list 99 funds covering tax-free national municipal bonds with over $45 T in AUM, so narrowing down that lot to a manageable number of candidates to research can be daunting. I identified several that looked to be potentially appealing based primarily on criteria set out by Eli Mintz using the relationship between return on NAV and discount as a filter. Briefly, Mintz noted a modest linear relationship between the two metrics and argued that funds falling well below the linear trend line were most worth exploring when making new purchases. I received some excellent feedback in the comments to that article. In particular, several readers pointed to two Eaton-Vance funds as being among today’s best opportunities in tax-free CEFs. In this article I want to expand in greater detail some of the funds previously noted plus the two Eaton-Vance offerings. The funds I’ll discuss are: MFS High Yield Municipal Trust (NYSE: CMU ) Dreyfus Municipal Bond Infrastructure Fund, Inc. (NYSE: DMB ) Eaton Vance Municipal Bond Fund (NYSEMKT: EIM ) Eaton Vance Municipal Bond Fund Ii (NYSEMKT: EIV ) MFS Municipal Income Trust (NYSE: MFM ) Nuveen Municipal Advantage Fund Inc (NYSE: NMA ) Nuveen Municipal Market Opportunity Fund Inc (NYSE: NMO ) Nuveen Select Quality Municipal Fund Inc (NYSE: NQS ) Nuveen Dividend Advantage Municipal Fund 2 (NYSEMKT: NXZ ) Nuveen Dividend Advantage Municipal Fund 3 (NYSEMKT: NZF ) Invesco Trust For Investment Grade Municipals (NYSE: VGM ) Invesco Advantage Municipal Income Trust II (NYSEMKT: VKI ) Invesco Municipal Opportunity Trust (NYSE: VMO ) This is a mixed group with some focused on high yield, others on credit quality, others on duration. The funds that appeared most interesting using Mintz’s criteria, which emphasizes high NAV return and deep discounts tend to push further out on the credit-quality scale, have longer durations, and relative high percentages of their portfolios subject to AMT. As the appeal of these funds is tax-free income, the AMT issue can be a deal breaker for some investors. Here is a heat-map table summarizing Discount, Distributions, Net Investment Income, Average Portfolio Maturity and Leverage. (click to enlarge) The next chart compares credit quality among the funds. On the horizontal axis, I’ve listed the funds and, in parentheses, their average portfolio credit rating based on number of bonds (data from Morningstar ). (click to enlarge) The superior credit quality of the two Eaton-Vance funds (EIM, EIV) is clearly evident in this chart. The percentage of each portfolio’s bonds that is subject to AMT shows a wide range as seen in the next chart. EIM and EIV are zero-AMT funds. The MFS funds (CMU and MFM) carry the highest AMT liabilities at 24% for MFM and 22% for CMU. The Nuveen funds (NMA, NMO, NQS, NXZ and NZF) are lowest of the non-zero group with the Invesco funds (VGM, VKI and VMO) intermediate. EIM and EIV are zero-AMT funds. The MFS funds (CMU and MFM) carry the highest AMT liabilities at 24% for MFM and 22% for CMU. The Nuveen funds (NMA, NMO, NQS, NXZ and NZF) are lowest of the non-zero group with the Invesco funds (VGM, VKI and VMO) intermediate. The next table shows effective durations, unadjusted and adjusted for leverage: Effective Duration Unadjusted Adjusted for Leverage CMU 6.56 10.20 DMB 6.49 9.40 EIM 4.86 8.00 EIV 2.86 4.70 MFM 7.00 10.00 NMA 7.10 10.88 NMO 7.72 12.10 NQS 7.76 12.32 NXZ 7.47 11.31 NZF 8.29 12.80 VGM 7.97 13.44 VKI 7.71 12.97 VMO 7.82 13.11 Again, the Eaton-Vance funds, especially EIV, stand out from the pack. Summary The Drefus fund made this list on the basis of its deep discount (ranking 4th of the 99 funds screened) and a return on NAV near the median (51/99) which place it very high using the qualitative Mintz criteria. Leverage (10.39%) is low for this category (12/99), which helps to moderate risk for the fund. Duration is shorter than all but the Eaton-Vance funds, which reduces interest-rate risk relative to the rest of the pool. On the negative side, credit quality is low, averaging BBB- for the portfolio. Unfortunately, it has the highest negative net investment income in the field (99/99); the fund’s payout yield is 6.47%, but its actual yield is only 4.84%. One might reasonably expect a distribution cut soon. As the funds primary appeal is its high yield for low leverage, the specter of a dividend cut takes it out of my consideration. For investors primarily interested in high levels of tax-free income, the Invesco funds (VKI, VGM and VMO) might be most appealing. Next would come the MFS funds (CMU and MFM). VKI pays a tax-free 7.01% (2/99); excess NII is a negative -0.25%. The other two offer similar results. But these three funds use the highest levels of leverage to achieve those returns. For the entire universe of national tax-free CEFs, only 5 exceed 40% leverage, these three Invesco funds are among those five. For VKI, leverage is 40.54% (97/99) with VGM and VMO (96 and 95/99) only slightly behind. The MFS funds also offer high yields. CMU is paying 6.77% (11/99) and MFM pays 6.31% (47/99). Unlike the Invesco funds, they do so without paying shareholders more than they are taking in. CMU’s excess NII of 0.72% ranks 3/99 for the tax-free muni-bond CEF universe and MFM’s 0.49% ranks 6/99. It would appear their yields are safe for the near term. Leverage is moderate, CMU carries 35.56% (55/99) and MFM carries 30.04% (25/99). CMU’s average portfolio credit rating of BBB- is low, but not out of line with the Invesco funds. MFM is much better at BB+. None of these high-yielding funds would appeal to investors who place a high priority on minimizing AMT, however, as they are among the highest for this metric. The Nuveen funds carry deep discounts, which drive moderately high yields from less risky portfolios. Those discount range from the mid -13%s to the mid -14%s. and rank 5, 7, 8 and 13 of all 99 funds. This generates yield near 6% (5.93 to 6.09%) from moderate leverage (32.13 to 33.98%), which clusters the fund near the lower mid-range of leverage for all funds. Credit quality is intermediate for the group (all BBB average rated except NXZ at BBB-). I’ll close with the Eaton-Vance funds. These are clearly the best for a more conservative investor who is more interested in credit quality (A- for EIM and AA for EIV) than yield (6.28% for EIV, ranking 49/99 and 5.91% for EIV, 68/99). For investors subject to AMT, the fact that they are AMT free can enhance those yields on a tax-equivalent basis as well. Leverage is high, however; both fall into the top 10% of all funds. These funds did not make the cut in my initial analysis because that exercise depended heavily on Mintz’s relationships between NAV return and discount. From that point of view EIV falls directly on the trend line and EIM, with its greater discount, falls moderately below it. As respondents to my last article, especially wiseone123 and Johan2003 , point out these funds have strong portfolio, attractive yields and discounts and should be considered strong candidates by anyone looking for entries into muni-bond CEFs at this time. Thanks to the commenters on the previous article for their excellent feedback, especially with regard to the Eaton-Vance funds, which certainly appear to be the choice of the lot. If one were to follow Mintz’s lead, then EIM would probably be the better choice of the two, but this comes at the cost of reduced portfolio credit quality. The most conservative investor would likely choose EIV with its high credit quality, low duration and reasonably high yield. Even using Mintz’s criteria, the fund is a reasonable buy as it is not in the more problematic space above the trend line. (For discussion of the NAV distribution/discount relationship with a summary of all 99 funds, see my earlier article, linked above.) Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Birchcliff Energy – Waiting For A Higher Gas Price

Summary Birchcliff’s production rate is higher than anticipated and has reached a new quarterly record. This allows the company to increase its production guidance and to reduce its capex guidance. I’m hoping for a long and harsh winter that will cause the natgas prices to spike, providing relief for Birchcliff’s balance sheet. Introduction As I remain convinced the oil and gas price won’t stay forever at the current levels (I even expect the gas price to increase a bit due to the construction of LNG plants to ship the gas to Europe and Asia where the price is 3-4 times higher), I have started to look for some interesting oil and gas companies. I came across Birchcliff Energy (OTCPK: BIREF ), a Canadian gas company (with some oil production as well) and decided to dig a bit deeper in this relatively large producer. Birchcliff is a Canadian company and has its main listing on the Toronto Stock Exchange with BIR as its ticker symbol. The average daily volume is almost 300,000 shares and the current market capitalization is approximately US$610M. The production rate continues to increase, but so does is the net debt Birchcliff had a pretty decent second quarter of this year as the average production during the quarter was almost 38,500 boe per day at an operating cost of just $4.53 per boe. This production rate is a new record for the company and emphasizes it’s still very focusing on expanding its production rate in order to build shareholder value. Source: press release In fact, the production growth was so impressive, Birchcliff’s management team has now increased the average production guidance for the fourth quarter of this year. Instead of producing an average of 39,000 boe per day, Birchcliff now expects to produce 41,000 barrels per day, a 5% increase. On top of that, I’m also expecting the production cost to continue to decrease a bit. I’m not complaining at all about the current cost of C$4.53 (US$3.4) per boe (which is an amazing result compared to the $5.25/boe in Q2 2014 and the $5.11/boe in Q1 2015), as the weak Canadian Dollar is definitely an advantage for Birchcliff Energy. (click to enlarge) Source: press release Despite the crash in the oil price (and the weaker gas price which is more important for the company as 86% of its production is natural gas), Birchcliff was able to realize a funds flow netback of just over $13 per boe which isn’t bad at all, considering the circumstances. Additionally, Birchcliff has now reduced its capital expenditure guidance from C$267M to C$250M (US$190M). This won’t be covered by the operating cash flow though as I’m not expecting the operating cash flow to be higher than C$175M (US$130M), so Birchcliff’s debt will very likely continue to increase. As of at the end of the second quarter, Birchcliff had drawn down roughly C$600M from its C$800M ($600M) credit facility, so it can draw down another C$200M (US$150M) to cover for the shortfall. The stronger-than-expected output provides a solid basis for next year Not only was Birchcliff able to increase its production guidance for the fourth quarter of the current year, this also bodes very well for next year. The increased production guidance for Q4 of 41,000 barrels per day is an ‘average’ daily production, and Birchcliff is expecting the exit production to be 41,000-42,000 boe per day, and this production increase will be underpinned by an updated of the company’s oil and gas reserves after seeing excellent production results from the horizontal wells drilled in the past 18 months. In fact, Birchcliff isn’t just hinting at a reserve increase, it says it expects the reserve increase to be ‘material’, so that should also have a positive impact on the NPV of the company as a whole. The winter season is coming closer, and those months are usually the best months for the gas price which could see a substantial price increase, boosting Birchcliff’s financial performance. It will be very interesting to see how the gas price will behave in the run-up to 2016, as a weak gas price will probably mean Birchcliff might have to defer some more capital expenditures as it knows it cannot stretch its balance sheet too much. Investment thesis Birchcliff’s financial performance will almost entirely be determined by the strength of the gas price in the upcoming winter. Whereas the gas price (Henry Hub) for delivery in September is trading at $2.64 , the futures for natural gas with delivery for January and February is trading at $3 and this will help Birchcliff’s financial performance. (click to enlarge) Source: CME Group I like Birchcliff’s limited exposure to oil (10% of its production) and focus on natural gas (86% of its output) and the next few quarters will be crucial for the company. I’m hoping for a long and harsh winter as that should bode well for all natural gas producers and result in a decent relief for its balance sheets. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BIREF over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This Small-Cap International ETF Is Really Growing On Me

Summary SCHC has incredible diversification within the holdings. The ETF needs to be combined with domestic equity ETFs and bond ETFs to be at its best. The expense ratio is higher than most of the ETFs I’m considering, but .18% is better than most international ETFs. I may need to sell off some VNQI and add some SCHC. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m contemplating changing the way I structure my portfolio and I’m going to be analyzing several of the ETFs that I am considering. One of the options is the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio is .18% which is one of the higher expense ratios out of the ETFs I’m consider, however it is vastly lower than many international options and is in a fairly small niche with targeting small-cap international equity. Most international equity funds would simply hold the international companies with larger market capitalizations. This ETF is nice because it allows investors a different exposure. Largest Holdings The internal diversification is out of this world. There are no holdings higher than 1% and only 1 that is higher than .45%. For getting diversification of holdings into the portfolio SCHC is a very impressive option. (click to enlarge) The diversification includes over 1600 companies which is more than I can recall for any of the international ETF options I’ve considered. Investors should be aware that during periods of financial stress in the international markets the correlation of returns is increased so SCHC may exhibit high correlation despite having very different holdings. I would treat that correlation as a market failure and just keep rebalancing the portfolio as necessary. Even if the high correlation in international investments is a market failure that does not reflect underlying value, remember that values can remain irrational for longer than some investors can remain solvent. Building the Portfolio I put together a hypothetical portfolio using only ETFs that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Best Partners SCHC stands to benefit from being mixed with bond funds. The longer bond funds such as TLO and ZROZ exhibit the strongest negative correlation at -.42 and -.44 respectively. To reach a more optimal portfolio when using SCHC it would be wise for the investor to use a material allocation to bonds. Within the equity investments the lowest correlations are SCHH and SCHD. When I first looked at SCHC last year, I didn’t like it as much because the .18 expense ratio was higher than I wanted to pay on my ETF investments. I do have a strong desire for low expense ratios, but I think SCHC is investing in a smart area. Small capitalization was a great area for indexing in the U.S. market for a long time before investors caught on and widespread use of whole market indexes and broad market indexes allowed the average investor to gain effective small-cap exposure. While the international markets used in SCHC are reasonably developed, there may still be some outperformance in those markets. At the very least, there are 1600 companies that won’t get heavy exposure anywhere else in my portfolio. Conclusion I like SCHC now more than I did when I first looked at it. Perhaps it is simply seeing the market fall in August, but I’m placing a larger emphasis on designing my portfolio to be simple for rebalancing and to drive the portfolio volatility down. Currently all of my international equity exposure is through SCHF and the Vanguard Global ex-U.S. Real Estate ETF (NASDAQ: VNQI ). I’m contemplating selling off the VNQI and reallocating it to Schwab funds to make my portfolio easier to rebalance and to take advantage of lower expense ratios. I like the use of international REITs in VNQI, but I don’t like the expense ratio of .24%. I may initiate a small long position in SCHC in the near future. As of submission, I have a small limit buy order entered that is significantly below the market price. If shares take a sudden fall, I will be starting a small position. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH, VNQI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.