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  • Municipal Bonds

    Muni CEFs: Enticing Tax-Exempt Income and Diverse Exposure

    Michael Laitkep
    January 14, 2021
     
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    With interest rates low and investors hunting for yield, municipal bonds could be attractive options for those seeking income given considerable yields with tax advantages. The S-Network Municipal Bond Closed-End Fund Index (CEFMX) is comprised of closed-end funds from an array of leading fixed income managers, providing diverse exposure to municipal bonds and ensuring a basket of funds that are representative of the space. The index methodology also utilizes a smart beta approach to give investors an opportunity to take advantage of fund discounts to their net asset values (NAV). This piece covers the differentiated design of CEFMX and the advantages of the index’s smart beta approach. CEFMX serves as the underlying index for the VanEck Vectors CEF Municipal Income ETF (XMPT).

    Introducing Municipal Bonds and the Closed-End Fund Structure.

    Municipal bonds (also commonly known as muni bonds or munis) are debt securities issued by state and local governments to fund day-to-day operations and major projects such as building schools, highways, or sewer systems. There are two primary types of munis, general obligation (GO) bonds and revenue bonds. With GO bonds, governments pay back the bonds out of their general funds or with tax increases, while revenue bonds, in contrast, are repaid using the income generated from the project being financed, such as toll fees or airport revenue. Muni bonds are also unique in their generation of interest income that is tax-exempt at the federal level, which can be advantageous for yield-seeking investors.

    Muni bonds can be accessed through a variety of products, but the closed-end fund structure has unique features relative to other options. Closed-end funds (CEFs) are mutual funds with greater portfolio efficiency since they are closed to new contributions and redemptions, meaning funds do not have to hold cash for possible redemptions. The CEF structure also allows for investment in less liquid bonds, which can benefit performance by permitting portfolio managers to invest in munis with more risk but higher returns. CEF managers are also able to actively manage their portfolios and utilize leverage to enhance performance.

    CEFMX Provides Diverse Muni Exposure With Limited Turnover.

    CEFMX is a composite index designed to capture the municipal bond space by tracking a diverse portfolio of muni CEFs. In order to be included in the index, closed-end funds must fall into one of four muni CEF sectors: Leveraged, Unleveraged, Leveraged High Yield, and Unleveraged High Yield (see chart below). In addition, funds must have total assets of at least $100 million, maintain a management fee below 1.5%, and have average daily turnoverof more than $500,000 per day for the three months prior to the record date. For existing constituents, buffers on certain screening criteria help limit index turnover, which can be a drag on index performance.

    CEFMX differentiates itself from muni funds focused on a single region or style by providing diverse muni exposure that is representative of the space overall. The index portfolio includes 64 CEF constituents from 14 different leading fixed income fund managers such as PIMCO, BlackRock, and BNY Mellon. Fund constituents employ a variety of muni trading and investment strategies that consider factors like yield, valuation, and tax sensitivity. While municipal bond holdings in portfolios can be concentrated in a single state or region, CEFMX provides exposure to most U.S. states. As shown in the chart below, only Illinois makes up more than 10% of the index by weighting, and the bottom 40 states make up 36.7% of the index.

    CEFMX Provides Broad Muni Sector Exposure, Though Leveraged Muni CEFs Dominate

    CEFMX Provides Broad Muni Sector Exposure, Though Leveraged Muni CEFs Dominate

    CEFMX Provides Diversification Across States          

    CEFMX Provides Diversification Across States

    Source: S-Network Global Indexes as of December 31, 2020

    Profiling CEFMX and Assessing Performance.

    Given different fund objectives and strategies, the CEFs in CEFMX include muni bonds with a wide range of credit ratings, though the index tilts toward higher quality credits. As of December 31, 78.4% of the individual issues included in the closed-end funds in the CEFMX Index are rated investment grade, while 8.6% are high yield and 13.0% are unrated. As shown in the table below, the weighted average leverage for the index is 34.5%, with most of the index’s constituents employing leverage to enhance yield and performance. CEFMX’s weighted average maturity of 18.4 years and effective duration of 9.3 years indicate a relatively high sensitivity to maturity risk and interest rate risk, though the index has had strong performance to match. As of December 31, CEFMX has returned 35.8% on a total-return basis over the last five years compared to 20.1% for the S&P National AMT-Free Municipal Bond Index (SPMUNUST), a muni benchmark (see chart below).

    S-Network Municipal Bond Closed-End Fund Index (CEFMX) Fast Facts
    Total Constituents 64
    Number of Unique Fund Managers 14
    Weighting of Top 10 Constituents 48.4%
    Investment Grade Weighting 78.4%
    Weighted Average Leverage 34.5%
    Weighted Average Effective Duration 9.3 years
    Weighted Average Maturity  18.4 years

    Source: S-Network Global Indexes as of December 31, 2020

    CEFMX Has Outperformed SPMUNUST Over the Last Five Years

    CEFMX Has Outperformed SPMUNUST Over the Last Five Years

    Source: S-Network Global Indexes, Bloomberg as of December 31, 2020

    CEFMX Takes Advantage of Closed-End Fund Discounts.

    Closed-end funds frequently trade at discounts to their NAV, meaning the share price is lower than the NAV. During periods of volatility, CEFs may initially trade at a wider discount to NAV, but the discount can narrow as market dynamics and pricing stabilize. In this scenario, buying the CEF at a discount would drive a higher yield. CEFMX’s smart beta weighting scheme is designed to exploit CEF discounts to its advantage. CEF constituent weights in the index are based on total net assets and adjusted for each fund’s average discount for the previous 90 days. Funds trading at higher discounts receive a greater weight in the index, while CEFs that trade at average premiums of 20% or more are excluded. As of December 31, CEFMX’s average discount to NAV is 4.0% and rests slightly beneath the historical average of 5.3% given some narrowing recently. However, the chart below shows that the index has historically retained a considerable weighted average discount. Wide discounts are a feature of the index and represent an opportunity for investors hoping to enhance yields.

    CEFMX Historical Discounts

    December 2005 to December 2020

    CEFMX Historical Discounts

    Historical average represents the average of the data points shown.
    Source: S-Network Global Indexes, Bloomberg as of December 31, 2020

    CEFMX’s Yield Compares Favorably to Other Fixed Income Sectors.

    In addition to broad exposure to muni CEFs, perhaps the most apparent case for CEFMX is yield given the current low-rate environment. As of December 31, CEFMX is yielding 4.4%, which is 220 basis points above SPMUNUST and well above U.S. Treasuries and the Bloomberg Barclays US Aggregate Bond Index (LBUSTRUU). In addition to significant yield, income generated from munis is generally exempt from federal taxes, with further tax benefits on the state and local level possible depending on the issue location and the investor’s residence. These tax benefits are especially advantageous for investors in a high federal tax bracket since muni bond yields are often higher on an after-tax (or tax-equivalent) basis. Investors should consult with a tax advisor for guidance specific to their situation. Combining the benefits of tax-exempt yield, diverse muni exposure, and strong performance, CEFMX has proven a differentiated index offering in the municipal bond closed-end fund space, and these features may be especially attractive in a low interest rate environment.

    CEFMX Yield Compares Favorably to Other Fixed Income Categories

    CEFMX Yield Compares Favorably to Other Fixed Income Categories

    Source: S-Network Global Indexes, S&P Dow Jones Indices, Bloomberg as of December 31, 2020

    CEFMX serves as the underlying index for the VanEck Vectors CEF Municipal Income ETF (XMPT).

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  • Authored by

    Michael Laitkep