Tax Free Income From Municipal Bond Closed End Funds
Summary Municipal bond CEFs offer attractive income free from federal taxes. In this article I explore the current muni-bond CEF space. Top funds for key metrics are discussed. Two funds that stand out on the basis of discount and NAV distribution yield are called out as particularly attractive at this time. Life changes and market changes: Both loom on my horizon. The first is unstoppable; the second is uncertain. And taken together they are exerting impacts on my portfolio. Regarding market changes: My view of macro events has led me to re-position my portfolio to a more defensive stance. One consequence is that I’m finding myself with more uninvested cash than I’m comfortable with, especially in my taxable income account where I have been trading out of high-risk, high-yield holdings. Life changes are also having an effect. These speak to my own case as an individual. But all my life I’ve been only a step or two ahead of a demographic tsunami, so I know many others will soon be dealing with similar issues. I’ll soon be putting another zero-birthday up on the scoreboard. This time a seven comes in front of the zero, a milestone that carries major tax consequences. First, my income will jump as I begin to draw social security retirement benefits, which I’ve put off as long as I could. This is a welcome addition and means I can comfortably give up some ground on income yield from my investments. But it also means more taxable income. In addition, in 2016 I will have to begin taking required minimum distributions – RMDs – from my tax-deferred accounts. This adds yet another increment to my taxable income. So, tax efficiency has become an important consideration. High yields are fine, but not if they come with a tax bill of staggering proportions. One outcome of these two pressures is that I continue to increase my allocation to tax-free municipal bonds in my income portfolio. There are other strategic moves underway, but for today’s topic I want to cover the muni bond space. I plan to follow up with a review of other tax-efficient income investments by early next week. As regular readers are aware, my strong preference for tax-free income is to invest in muni-bond closed-end funds. Tax-equivalent income from the CEFs is quite favorable compared to many other fixed-income sources. And it is much better than can be earned from holding individual municipal bonds or other municipal bond funds (EFTs or mutual funds). That attractive income comes, unsurprisingly, with risks. The high yields are partially generated by employing leverage, so it comes with the risk that leverage carries. In choosing funds I try to moderate some of that risk by looking for funds that are experiencing sharp downward moves in their premium/discount status. My assumption is that P/D status often tends to revert to mean values over time, so buying funds at an outsized discount (relative to the fund’s individual history) can help cushion some of the leverage risk. Of course there is often a very good reason for a sharp change in P/D status. In such cases, any confidence in mean reversion must be tempered by the full situation. In addition to leverage risk, muni bonds, like all fixed-income investments, are subject to interest rate risk. But the fact that many of these funds can sell at hefty discounts to their net asset values can help to moderate this risk to some extent. Interest rate fears tend to drive prices down, often well out of sync with interest-rate driven declines for NAVs. This creates deeper discounts. Keeping in mind all the usual caveats about the impossibilities in timing markets, an awareness of changes in P/D status as a reflection of investor psychology can often help moderate interest rate risk by opening opportunities to purchase a fund at a bargain rate. For example, ten months ago (Oct. 2014) I looked at muni bond CEFs here and noted that the space looked to be marked by extreme over-selling, likely a result of interest-rate anxieties. I considered those interest-rate fears overblown and came to a conclusion that bargains were common. I picked out five funds I particularly liked at the time. When I next wrote about muni bond CEFs 4 months later (Feb, 2015) those five funds had returned an average of 7.62% vs. 1.38% for the largest muni bond ETF, the iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA: MUB ), much of it due to discount compression as interest-rate fears faded. But, by Feb 2015 the market had corrected the anomaly of a few months previous and bargains were scarce. It was, as I noted, not a good time to be a buyer in the muni-bond CEF market. I did select three funds at that time despite the paucity of attractive buys, but those three have lost 2.31% while MUB has only dropped -0.95%. This illustrates the importance of timely entry into this market when investor fears outweigh the actual risks. I’m not sure we are quite at that state now, but I expect it’s not far off. In any case, today’s muni bond fund market is, to my mind, much more buyer-friendly than it was in February. The muni-bond CEF space is large. There are at least 99 national muni CEFs and dozens more single-state funds. I’ll restrict my thoughts here to the 99 national funds covered by cefanalyzer . Those of us who live in high-tax states are likely to generate better after-tax returns with a state fund. For my own portfolio, I am invested in California state muni-bond CEFs. Tax-Equivalent Yield One of the things I like to do when discussing muni bonds is to present an overview of tax-equivalent distributions for marginal tax rates to make it easier for readers to determine what the yields mean to them. Most summaries of muni-bonds report tax-equivalent returns based on the highest marginal rates. Few of us qualify for those rates, so it’s important to consider one’s unique situation in deciding if a muni bond investment is appropriate. (click to enlarge) There are good taxable equivalent rate calculators on-line. My favorite is from Eaton-Vance ( found here ). It incorporates state income tax rates and the state-to-state variation in how muni bond income is handled. Distribution Yields Let’s start with a look at current distributions for the universe of national muni-bond CEFs. Distribution rates range from a low of 3.24% to a high of 7.38% (median = 6.18%). The full range for distribution rates looks like this: The top five funds for distribution at Market Price are: Distribution Price Distribution Price Discount Pioneer Municipal High Income Advantage Trust (NYSE: MAV ) 7.50% 5.00% Eaton Vance Municipal Income Trust (NYSE: EVN ) 7.00% 1.42% Dreyfus Municipal Income Inc (NYSEMKT: DMF ) 6.98% -5.01% Pimco Municipal Income Fund (NYSE: PMF ) 6.96% 8.95% Invesco Advantage Municipal Income Trust Ii (NYSEMKT: VKI ) 6.96% -9.38% And, the top five for distribution at Net Asset Value are: Distribution NAV Distribution NAV Discount Pioneer Municipal High Income Advantage Trust MAV 7.88% 5.00% Pimco Municipal Income Fund PMF 7.58% 8.95% Eaton Vance Municipal Income Trust EVN 7.10% 1.42% Pimco Municipal Income Fund Iii (NYSE: PMX ) 6.95% 2.51% Nuveen Municipal High Income Opportunity Fund (NYSEMKT: NMZ ) 6.73% -1.33% I’ve included Discount(/Premium) in the distribution tables because there is a strong message in the relationships. Note that funds with high distributions on NAV tend to sell at a premium. This is a widely seen phenomenon in closed end funds, where investors focus strongly on income and distribution rates. That focus tends to adjust premium/discount status in the direction of an equilibrium distribution on price. Thus funds with low to modest NAV distributions tend to get priced down; they will sell at deep to modest discounts. This does, of course, increase the distribution rate bringing them more in line with funds that have high NAV distributions. At the same time, the high NAV-distribution funds tend to get priced up into premium ranges thereby reducing their distribution rate from the NAV value. MAV, which holds top positions in both distribution metrics illustrates this. Its 7.88% NAV distribution drops to 7.5% after the 5.0% premium takes its bite. VKI, by contrast, lags well behind MAV on NAV distribution at 6.31% (which ranks a respectable 12th of the 99 funds). But its -9.38% discount drives the distribution on price to 6.96% pushing it into the top five for market yield. MAV is an interesting case to illustrate the downside of being too focused on high yield when selecting a fund. MAV had been selling at an outsize premium (approaching 25%) as recently as May of this year. But, as should have been clear to investors, that premium was generated by an unsustainably high distribution rate. In May the distribution was cut from $0.095 to $0.08/share, a drop of -15.7% and the premium fell from a high of 24.48% to near par (0.08%) late in July. As seen in the table above, the premium has picked up a bit in the past three weeks. NAV Yield, Discount/Premium, and The Move Toward Equilibrium Eli Mintz has documented the relationship between NAV yield and Discount/Premium status in an excellent article ( here ). He argues that the relationship between NAV distribution rate and Discount/Premium is a primary factor to be considered in evaluating municipal bond CEFs. Following his lead, I’ve plotted the current values with a linear trendline for these metrics for the 99 funds under consideration. (click to enlarge) Mr. Mintz advocates choosing among funds that fall well under the trend line, so I’ve narrowed the chart to show those funds posting discounts below -5.00%. (click to enlarge) Selection from the lower thresholds of this distribution produces several that look worth exploring on the basis of this metric. But, as we can see in the next table, some are paying out distributions that exceed their actual net investment income (NII Yield). NII calculations are done on a market price basis for the table. On this basis, CMU and MFM look particularly attractive. CMU has a discount below 10%. Its NAV distribution of 6.03% generates 6.73% for its current market rate. And with an excess NII yield of 71bps above distribution, the yield appears secure. MFM sports a discount just shy of -13% and a NAV distribution at 5.44% which generates 6.25% distribution yield. It, too, appears to be earning that distribution with net investment income 48 bps above its distribution yield. This is illustrated in the heat map distribution seen in the next table: Leverage and Duration I’ve included two indicators of risk here, average portfolio maturity and percent leverage. CMU’s leverage (35.56%) is about the middle of the pack for the muni bond CEF space, ranking 55 of the 99 funds. MFM carries less leverage. Its 30.04% leverage ranks 25th in the space. Maturity can provide some indication of interest rate risk. Duration adjusted for leverage would be preferred but this is not a metric that is available through the screeners I use. The average maturities of the CMU and MFM portfolios both stand at 18.6 years, ranking 66 of 99. For this set of funds, the Nuveen offerings (NMA, NMO, NQS, NXZ and NZF) might appear to be better positioned for interest rate risk on the basis of portfolio maturity. But, when portfolio duration is calculated this is not supported. Fund Duration (Unadjusted) Duration (Leverage Adjusted) CMU 6.56 10.20 MFM 7.00 10.00 NMA 7.10 10.85 NMO 7.72 12.10 NQS 7.76 12.32 NXZ 7.47 11.31 Summarizing Other Metrics I’ll close with a summary of the top five funds for some other metrics for readers who may be interested in exploring funds leading for these categories. Along with the ranking metric, I include discount, distribution rates, NII yield and NII excess. The top five funds for discount: Discount Dist Dist (Price) NII yield Excess Nuveen Quality Municipal Fund Inc (NYSE: NQI ) -13.62% 4.61% 5.34% 5.55% 0.21% Nuveen Dividend Advantage Municipal Fund 2 NXZ -13.07% 5.25% 6.04% 5.62% -0.42% Nuveen Municipal Market Opportunity Fund Inc NMO -13.02% 5.08% 5.84% 5.92% 0.08% MFS Municipal Income Trust MFM -12.91% 5.44% 6.25% 6.73% 0.48% Nuveen Dividend Advantage Municipal Income Fund (NYSEMKT: NVG ) -12.82% 4.77% 5.47% 5.66% 0.19% Top five for Total Return (Price) for one year: TR Price 1Y Discount Dist Dist (Price) NII yield Excess Western Asset Managed Municipals Fund Inc. MMU 11.92% -1.03% 5.52% 5.57% 5.55% -0.02% Western Asset Municipal Defined Opportunity Trust Inc. (NYSE: MTT ) 11.85% 6.49% 4.47% 4.19% 4.40% 0.21% Mfs Investment Grade Municipal Trust (NYSE: CXH ) 10.77% -7.45% 4.90% 5.29% 5.63% 0.33% Nuveen Municipal High Income Opportunity Fund NMZ 10.25% -1.33% 6.73% 6.82% 6.93% 0.11% Blackrock Muniassets Fund, Inc. (NYSE: MUA ) 10.21% -1.65% 5.38% 5.47% 5.35% -0.12% Top five ranked for Total Return for one year: TR NAV 1Y Discount Dist Dist (Price) NII yield Excess Delaware Investments National Municipal Income Fund (NYSEMKT: VFL ) 11.15% -11.32% 5.35% 6.03% 5.50% -0.53% Eaton Vance Municipal Income Trust EVN 9.10% 1.42% 7.10% 7.00% 6.89% -0.11% Western Asset Municipal Partners Fund Inc. (NYSE: MNP ) 8.13% -9.59% 5.24% 5.80% 5.53% -0.27% Western Asset Managed Municipals Fund Inc. (NYSE: MMU ) 7.77% -1.03% 5.52% 5.57% 5.55% -0.02% Pimco Municipal Income Fund Iii PMX 7.07% 2.51% 6.95% 6.78% 6.98% 0.20% Top five for one-year Z-Scores, a measure of the extent to which the current discount/premium varies from the average discount/premium for the past year. Readers unfamiliar with Z-Scores can read about the metric here . Z-Score 1Y Discount Dist Dist (Price) NII yield Excess MFS Municipal Income Trust MFM -2.00 -12.91% 5.44% 6.25% 6.73% 0.48% Nuveen Municipal Income Fund Inc (NYSE: NMI ) -1.80 -6.06% 4.38% 4.66% 4.77% 0.11% Nuveen Municipal Market Opportunity Fund Inc NMO -1.63 -13.02% 5.08% 5.84% 5.92% 0.08% Western Asset Intermediate Muni Fund Inc. (NYSEMKT: SBI ) -1.63 -7.12% 4.61% 4.96% 4.46% -0.50% Pioneer Municipal High Income Advantage Trust MAV -1.56 5.00% 7.88% 7.50% 7.43% -0.08% I’ll add the following chart which shows the distribution of 1-yr Z-Scores for all funds considered here. It provides a useful touchstone to compare with similar charts from previous articles to compare trends in the municipal bond CEF universe. I’ll close with the seven funds having the shortest average portfolio maturities. But keep in mind, as noted above, this is not a stand-in for leverage-adjusted duration, the preferred metric for evaluating interest-rate risk. Leverage-adjusted duration can usually be found on the sponsor’s web pages for a fund. I do not know of a screening tool that uses this metric. If any reader is aware of one, I would certainly appreciate your sharing that information. Maturity Discount Dist Dist (Price) NII yield Excess Blackrock Municipal 2018 Term Trust (NYSE: BPK ) 5.4 -0.65% 3.64% 3.66% 3.99% 0.33% Nuveen Select Maturities Municipal Fund (NYSE: NIM ) 5.7 -2.78% 3.16% 3.25% 3.35% 0.10% Deutsche Strategic Municipal Income Trust (NYSE: KSM ) 5.9 -0.23% 6.55% 6.57% 6.41% -0.16% Deutsche Municipal Income Trust (NYSE: KTF ) 6.2 -4.67% 6.28% 6.59% 6.44% -0.14% Alliance Bernstein National Municipal Income Fund (NYSE: AFB ) 6.3 -7.81% 5.48% 5.94% 6.20% 0.25% Eaton Vance Municipal Bond Fund Ii (NYSEMKT: EIV ) 6.3 -7.78% 5.41% 5.87% 5.86% 0.00% Putnam Municipal Opportunities Trust (NYSE: PMO ) 6.3 -10.08% 5.41% 6.02% 6.35% 0.33% Additional disclosure: I do not hold any of the funds discussed above. My municipal bond holdings are all in California state bond funds at this time. 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.
