Mazzilli's Municipal Musings – Part 1
- Wednesday, 03/26/2014
MUNI NATION invited Paul Mazzilli, a leading ETF and closed-end fund analyst, to provide a three-part commentary on the state of the municipal closed-end fund market.
Efficiency, Diversity, and Yield
I continue to be attracted to municipal bond closed-end funds (CEFs) given their compelling, tax-exempt yields and I believe that the Market Vectors CEF Municipal Income ETF (XMPT) is an efficient way to get diversified access to this market1. XMPT tracks the S-Network Municipal Bond Closed-End Fund Index (CEFMX) and, for those in the highest tax bracket, it is currently among the highest yielding ETFs that provide exposure to the municipal bond CEF market. Many buyers of CEFs may not get proper diversification or have the time to research individual CEFs. As a fund-of-funds, XMPT seeks to provide diversification by asset, strategy, and active manager.
There have been significant changes in municipal CEF market prices over the past year. In much of 2012 and early 2013, these funds were selling at premiums to their net asset values (NAVs) as investors were attracted to their high tax-exempt yields and, in my opinion, were perhaps complacent about the conditions of the overall bond markets. In mid-2013, municipal bond CEFs had significant downward price movements as the multi-year rally in bonds finally came to an end and they began to sell at discounts to their NAVs. Fears about further drops in bond prices, in part, caused discounts to widen continually far beyond their historical averages.
I believe a number of factors contributed to this weakness in municipal bond CEFs in the second half of 2013. These included: rising U.S. Treasury yields, anticipation of potential municipal bond CEF dividend reductions, concerns over the federal tax-exempt status of municipal bonds, increasing municipal bond supply, and the downgrade of Puerto Rico by major rating agencies. Furthermore, given the strong performance of municipal CEFs over the past five years and their rich valuations, it seems likely that the initial declines triggered more profit taking (realizing gains) by municipal CEF investors.
However, moving into 2014, the underlying market for municipal bonds appears to have stabilized and a recent $3.5 billion new issue by Puerto Rico has improved market sentiment. Puerto Rico is considered by many as the riskiest debt issuer in the $3.7 trillion U.S. municipal bond market. All three major rating agencies recently cut Puerto Rico's credit rating to junk, citing low liquidity and persistent economic troubles. The territory has roughly $70 billion in outstanding debt and has endured nearly eight years of recession. Most U.S. CEFs investing in municipal bonds have very low exposure to Puerto Rico because they are diversified by state and avoid weaker credits. However, I see the ability of Puerto Rico to complete a large financing as good for the municipal bond market in general.
1A portion of the Fund's dividends may be subject to federal, state, or local income taxes or may be subject to the federal alternative minimum tax (AMT). Yields of closed-end funds may reflect the return of principal or other non-income items such as loan proceeds or borrowings.
The Market Vectors High-Yield, Short High-Yield, Long, Intermediate, and Short Municipal Index ETFs invest assets in municipal bonds issued by Puerto Rico. (Click the preceding hyperlinks to view current geographic weightings.) This means the Funds are susceptible to additional risks, including economic, political, regulatory, or other factors adversely affecting issuers in Puerto Rico. Recent downgrades affecting these bonds may exacerbate Puerto Rico's current financial difficulties and the liquidity and risk profile of its outstanding bonds, which may affect these Funds. The Market Vectors CEF Municipal Income ETF (XMPT) does not invest in actual bonds; however some of the underlying CEFs held by the fund may invest in debt issued by Puerto Rico.
Principal Investment Risks:
Diversification does not assure profit nor protect against loss.
XMPT's performance, because it is a fund of funds, is dependent on the performance of the Underlying Funds. The Fund is subject to the risks of the Underlying Funds' investments, and the Fund's shareholders will indirectly bear the expenses of the Underlying Funds. In addition, at times certain segments of the market represented by the Underlying Funds may be out of favor and underperform other segments.
The shares of a closed-end fund may trade at a discount or premium to its net asset value ("NAV"). Additionally, the securities of closed-end investment companies in which the Fund will invest may be leveraged. As a result, the Fund may be indirectly exposed to leverage through an investment in such securities. An investment in securities of closed-end investment companies that use leverage may expose the Fund to higher volatility in the market value of such securities and the possibility that the Fund's long-term returns on such securities (and, indirectly, the long-term returns of the Shares) will be diminished.
Investment in the underlying funds may be subject to municipal securities risk, high-yield securities risk, fixed-income securities risk, tax risk, liquidity risk, leverage risk and anti-takeover measures risk. Some of the underlying funds are considered non-diversified and can invest a larger proportion of its assets in a single company. As a result, they may be subject to greater risks than a diversified fund.
A portion of the Fund's dividends may be subject to federal, state, or local income taxes or may be subject to the federal alternative minimum tax.
S-Network Municipal Bond Closed-End Fund IndexSM is calculated and maintained by S-Network Global Indexes, Inc. S-Network does not sponsor, endorse, or promote the Fund and bears no liability with respect to the Fund or any security.
Please note that the information in this post represents the opinions of Paul Mazzilli and not necessarily those of Van Eck Global. These opinions may change at any time and from time to time. This message is not intended to be a forecast of future events, a guarantee of future results, or investment advice. Current market conditions may not continue. Non-Van Eck Global proprietary information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Van Eck Global. MUNI NATION is a trademark of Van Eck Associates Corporation. Please note that Van Eck Global offers municipal bond exchange-traded funds. Please see the prospectus and summary prospectus for more information.
About Paul Mazzilli
Widely recognized as one of the leading exchange-traded fund (ETF) and closed-end fund (CEF) analysts, Paul Mazzilli has over 35 years of experience in the investment business. Paul is currently an independent Fund Consultant and a Senior Advisor to S-Network Global Indexes and Chairman of the Index Committee for the S-Network Closed-End Fund Indexes. He also is a Senior Advisor and member of Advisory Board at IndexIQ. Paul most recently was Executive Director at Morgan Stanley and Director of the firm's ETF research team, covering passively managed index-linked ETFs and actively managed closed-end fund companies, a broad range of funds listed on U.S. exchanges that invest in taxable and municipal fixed income, as well as equities in the U.S. and in international regions and countries. In addition, Paul was responsible for constructing asset allocation models using ETFs and developing Strategic Equity Portfolios (STEPs) investing in closed-end funds and ETFs.