Mazzilli's Municipal Musings – Part 2
- Wednesday, 04/09/2014
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.
Premiums, Discounts, and a Suitable Index
At this time, I believe the underlying market for municipal bonds looks favorable. Federal spending cuts, in my opinion, are not likely to affect municipal credits, and the U.S. economy continues to grow at a moderate rate, which is good for municipals. In addition, I believe last year's tax rate increase for the wealthiest Americans and the likelihood of further rate hikes, or losses of deductions, may help support the market for municipal bonds. However, as the market outlook appears better so far in 2014 compared to last year, closed-end funds (CEFs) investing in municipal bonds continue to sell at historically wide discounts. Buying CEFs at discounts, in turn, tends to increase the yield an investor may get on the market price. (See example below.) I believe that discount is likely to narrow over the next few months as the underlying municipal market stabilizes. Historically, as the market stabilizes, CEF discounts have tended to shrink as investors chased the potentially higher yields provided by the discounts.
"Yield Enhancement" and Absolute Discounts
- Let's assume that a fund's underlying portfolio at NAV yields 10%
Distribution = $1.00 per share
Net Asset Value (NAV) = $10.00 per share
Distribution Rate at NAV = $1.00 / $10.00 = 10%
- Let's further assume that the shares trade at a 10% absolute discount
Net Asset Value = $10.00 per share
Share Price = $9.00 per share
Absolute Discount = (share price – NAV) / NAV = ($9 - $10) / $10 = -10%
- Because they are buying at a discount, investors purchasing these shares will get a higher yield
Distribution = $1.00 per share
Share Price = $9.00 per share
Distribution Rate at Share Price = $1.00 / $9.00 = 11.1%
The "Yield enhancement" is calculated by distribution rate (share price) / distribution rate (NAV) or
11.1% / 10% = 1.1%
Source: Morningstar. Past performance is not an indication, or guarantee, of future results. Hypothetical or model performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading and accordingly, may have under- or over-compensated for the impact, if any, of certain market factors, such as market disruptions and lack of liquidity. In addition, hypothetical trading does not involve financial risk and no hypothetical trading record can completely account for the impact of financial risk in actual trading. Simulated performance is subject to the fact that it is designed with the benefit of hindsight. The actual performance of the ETP may vary significantly from the hypothetical data.
In my opinion, a good barometer for the market of CEFs investing in municipal bonds is the S-Network Municipal Bond Closed-End Fund Index, an index of 84 municipal bond CEFs (as of 3/31/14) that are selected and weighted using a proprietary rules-based methodology. The index uses a value approach to take advantage of pricing inefficiencies related to CEFs trading at discounts to their NAV. Unlike most ETF indices, which are market-cap weighted, this index weights initially by NAV so as not to give a greater weight to CEFs selling at richer valuations. It then tiers CEFs to overweight those selling at higher discounts and to underweight CEFs selling at lower discounts or premiums. This value approach is designed to increase the allocation to undervalued CEFs during quarterly index rebalancing and reduce exposure to more richly valued CEFs. On average, since its inception on June 3, 2011, the index has an average discount of 2% to 4% greater than that of its overall constituents. The index's members are primarily high-quality investment-grade municipal bond CEFs. The index receives a yield enhancement from the currently 84% of assets in leveraged CEFs in addition to the index rules designed to give a greater weight to CEFs selling at discounts to their NAVs. While leverage may enhance the yield, it can also magnify losses. As of March, 14, 2014, the components of the index traded at an average discount of -7.02% and the index's dividend yield was 7.41%. This index yield is the pre-tax equivalent of 12.26% for investors subject to the maximum Federal Tax rate of 39.6% and the pre-tax equivalent of 10.29% for those subject to the Federal tax rate of 28%.
The following chart shows the history of the average discount for the S-Network Municipal Bond Closed-End Fund Index and how the current level compares to historical levels.
S-Network Municipal Bond Closed-End Fund Index: Premium/Discount — 6/30/2011 – 3/31/2014
Source: S Network, as of March 31, 2014. Index performance is not illustrative of fund performance. Fund performance current to the most recent month end is available by visiting our website. Historical performance is not indicative of future results; current data may differ from data quoted. Indexes are unmanaged and are not securities in which an investment can be made.
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. 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 of 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.