Given the likely continuation of the record high yield environment for fixed income for the foreseeable future, potential periods of increased future volatility in equity markets, and attractive current returns relative to comparable taxable investments, municipal bonds and Investment strategies focused on municipal bonds, including funds (CEF), have been in high demand lately. For example, as you will see in the table below, all US-traded tax-free national municipal bond CEFs now trade, on average, above their average premium / discount over ten years. This has not been the case for the past two years.
Additionally, when it comes to municipal bond-focused mutual funds, U.S. municipal bond funds recently recorded their 28th straight week of fundraising. Consider the mutual fund flow information for municipal bond funds versus taxable bond funds below from the Trends in Mutual Fund Investing report from the Investment Company Institute (HERE) for the first two months. from 2016.
|Classification of mutual funds||February 2016||january 2016||January February
|Domestic actions||-3,330||-15,480||-18,809||8 376|
|Global Equities||10 820||10,507||21,326||13 599|
|Hybrid||-1 457||-10 639||-12,096||6 057|
|Taxable obligation||-3 980||-9,425||-13,405||19 914|
|Municipal obligation||4,690||4 269||8 959||7,230|
|Taxable money market||44,925||-10 874||34,051||-45 488|
|Tax-exempt money market||-7642||-9.372||-17,013||-2,039|
Overall, strong demand and the underlying weak supply of municipal bonds kept prices high and yields relatively low in the first quarter, but I expect demand to remain high for focused investment strategies. on municipal bonds for the remainder of 2016. Therefore, for those who wish to add or increase the municipal bond allocations through CEFs to their client portfolios, the following overview of CEF municipal bonds may prove useful.
At present, there are 176 closed-end funds in the non-taxable income category outstanding in 19 different strategies; some national and some state-specific, according to CEFConnect.com.
|Category||Strategy||# of CEF|
|Income tax free||High efficiency||6|
|Income tax free||national||88|
|Tax Free Income (State)||Arizona||2|
|Tax Free Income (State)||California||22|
|Tax Free Income (State)||Connecticut||1|
|Tax Free Income (State)||Florida||1|
|Tax Free Income (State)||Georgia||1|
|Tax Free Income (State)||Maryland||2|
|Tax Free Income (State)||Massachusetts||4|
|Tax Free Income (State)||Michigan||4|
|Tax Free Income (State)||Minnesota||2|
|Tax Free Income (State)||Missouri||1|
|Tax Free Income (State)||New Jersey||8|
|Tax Free Income (State)||new York||21|
|Tax Free Income (State)||North Carolina||1|
|Tax Free Income (State)||Ohio||3|
|Tax Free Income (State)||Pennsylvania||6|
|Tax Free Income (State)||Texas||1|
|Tax Free Income (State)||Virginia||2|
Since CEFs contain their own unique set of risk considerations, including, but not limited to, the use of leverage, it is in my view essential to employ a comprehensive set of risk criteria. selection beyond the simple search for CEFs that have the highest current yield and / or trade at the highest discount to their own net asset value (NAV). In this regard, some of the selection criteria that we take into account at SmartTrust when selecting municipal CEEs for our applicable Unit Investment Trust (UIT) strategies include, but are not limited to, the following:
- Market capitalization and liquidity – measured by total net assets, in US dollars, and average CEF trading volumes. I generally look for CEFs with total net assets of $ 100 million or more, taking into account average trading volume.
- Distribution rate – this is the current payout rate, or yield, of the CEF and is a measure of the current annualized payout amount divided by the current price, not the NAV.
- Distribution amount – current amount of cash distribution per share. We are only interested in regular income distributions and do not take into account returns on capital, special (i.e. non-regular) distributions, short-term capital gains and long-term capital gains.
- Earnings per share (EPS) – the most recent amount that the CEF has earned per share. We generally exclude CEFs with negative earnings per share.
- Profit / distribution coverage ratio – compares current income to current monthly distribution amounts where ratios greater than 100% indicate that the CEF is “over-hedged” from a profit / distribution point of view and ratios less than 100% indicate that the CEF is “ undercover ‘from a profit / distribution point of view. We prefer CEFs which have a high profit coverage / payout ratio.
- Net retained investment income (UNII) – the cumulative balance of a fund’s net investment income less distributions of net investment income. UNII appears in shareholder reports as a line on the statement of changes in a fund’s net assets. We see UNII as a cash buffer or cash reserve for a CEF portfolio. We generally do not consider CEFs with negative UNII balances.
- UNII / Distribution coverage ratio – compares the current UNII balances to the current monthly distribution amounts to determine how many months of distribution coverage are covered by the CEF UNII balance.
- Premium / (Reduction) –The amount for which the market price of a closed-ended fund exceeds (premium) or is lower (discount) than the net asset value (NAV) of this CEF. We argue that a CEF traded at a premium does not necessarily mean that it is overvalued and a CEF traded at a discount is not necessarily undervalued. There is nothing in writing that states that a closed-end fund (CEF) should always trade at its net asset value.
- Average premium over 52 weeks / (reduction) – to help assess the relative value of the current premium / (discount) for a given CEF, we compare the current / (discount) premium to the 52 week average premium / (discount). Such comparisons are made not only for the CEF itself, but also in relation to their category / strategy. For example, CEFs that trade below their 52 week averages represent a higher relative value to us than CEFs that trade above their 52 week averages.
- Effective leverage (and type of lever used) – CEF’s total exposure to economic leverage and includes structural leverage, which is calculated using the leverage created by preferred shares of a fund or debt borrowings by the fund, as well as the leverage exposure created by the fund’s investment in certain derivative investments (including, but not limited to, reverse repurchase agreements). Leverage is typically represented as a percentage of a fund’s total assets. Given the current record low interest rate environment, many CEF managers still currently use some form of leverage to improve their portfolio returns and take advantage of low relative borrowing costs. For example, about 97% of all tax-exempt income CEEs currently use some form of leverage. Recognizing that portfolio leverage can increase the volatility of a given CEF and that leverage itself may offer less value when short-term rates approach or exceed long-term rates, we lend particular attention to the type and amount of leverage that each CEF strategy employs, particularly given that we currently find ourselves in a period that is expected to be a long period of gradual rise in interest rates.
- Expense ratio – it is important to be aware of the effect that the underlying CEF expense ratios have on the overall performance of the strategy portfolio.
- Credit quality – most CEF sponsors report the breakdown of the credit quality of the underlying bond securities within their portfolios at different reporting periods.
- Maturity – most CEF sponsors report the maturities of the underlying bonds within their portfolios at different reporting periods.
- Adjusted Option Duration (ADO) – while not all CEF sponsors necessarily report the ADO of the underlying obligations within their portfolios at different reporting periods, financial software providers, such as Bloomberg, calculate and provide this information based on sensitivity to interest rates.
- Percentage of AMT – most CEF sponsors report the AMT percentages of the underlying bond holdings within their portfolios at different reporting periods. This information can be useful for portfolio allocations to new high net worth clients who are in a higher tax bracket.
- % of the pre-reimbursed portfolio – most CEF sponsors report the percentage of their portfolios that are pre-redeemed compared to the underlying bond holdings within their portfolios at different reporting periods. We generally look favorably on prepaid bonds. To appreciate our point of view, it is necessary to understand how prepaid bonds work. Pre-redeemed bonds are issued to fund another municipal callable bond, where the issuer of the municipal bond effectively decides to exercise its right to redeem its bonds before the expected maturity date of the bond. The proceeds from the issuance of the lower yielding and / or longer maturity bond will generally be invested in U.S. Treasuries until the scheduled call date of the initial bond issue, thereby reducing the risk of credit of the initial bond issue.
While no selection criteria can guarantee the success of a selected investment strategy, I believe the multi-factor approach described above can be useful in finding municipal CEFs that strive to pay high levels and sustainable tax-exempt income and deliver a total return. potential, throughout the lifespan of each CEF investment strategy.
Disclosure: Hennion & Walsh is the sponsor of SmartTrust® Unit Investment Trusts. The above overview is for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to buy ITU SmartTrust®.