Municipal Bond Bargains
December 05, 2018
On the closed-end municipal bond (muni) front, there are some very attractive opportunities, particularly in three of my favorite discounted closed-end muni bond funds.
To start, buying at a double-digit discount is a great idea for any investor. And by buying into my recommendation of the three funds together, they generate 36 payouts each year, which come from monthly dividend distributions.
But there’s more. Each of them also has a history of paying Christmas bonus checks to shareholders that have been even higher than the regular distributions.
Combined, the average discount to net asset value (NAV) is running at 12.22%. The average dividend yield—not counting year-end special distributions—is running at 5.73%. Of course, municipal bonds are exempt from Federal income tax, and so in order to make investors in the 35% tax bracket the same amount of money after taxes, a taxable bond would have to pay 8.81%, vastly higher than the average for US Treasuries and high yield corporates, and of course more than 400% higher than the dividend yield of the S&P 500 Index. (This is often called the taxable-equivalent yield.)
Let me expand on the muni market and why I see further value in the market for current income and appreciation over time along with well-supported credit behind the underlying muni issues.
Municipal bonds are offering some of the best yields for individual investors right now and continue to outperform US Treasuries almost three to one. US Treasuries over the past five years have a return of 6.91%, while munis have generated a return of 18.86%. This outperformance continues for the trailing twelve months.
And specific market and economic developments are providing an immediate opportunity for higher yields and appreciation over the coming quarters.
Municipal bonds have always been a great staple for investors looking for steady and dependable income. With the exemption from Federal income tax as well as specific state income tax, municipal bonds offer even better taxable-equivalent yields, particularly for investors in higher income tax brackets, which largely remained intact even after the passage of the Tax Cuts & Jobs Act of 2017 (TCJA).
The general market for municipals had a sell-off this past January when the impact of the corporate tax cut came into focus. The result is that with lower income tax rates for corporations, from 35% down to 21%, the attraction of municipal bonds to bank and insurance corporations became a bit less. And as these corporations were major owners of municipals as they sought yield, their selling is now providing the deal for you to scoop up.
For most investors, who are still paying Uncle Sam a 35% income tax rate, the allure and the advantages of municipals haven’t changed one bit.
As I said above, the best way to get the most from the immediate opportunity is to buy three closed-end municipal investment funds right now. Each is selling at a discount to their liquidation value of at least 9.8%, with the best at nearly 13%, and pay an average taxable-equivalent yield of 8.81%, as I noted above. I’ve followed and recommended these collectively for the diversity in their holdings across the US and how they tend to work well together in reducing month to month price volatility.
Look to buy the Blackrock Municipal Income Trust II (BLE). This is a value-focused municipal fund that’s at a discount at the moment of 11.73% to the net asset value. It yields 5.44%, which equates to a taxable equivalent of 8.37%.
Then add the Nuveen Municipal Credit Income Fund (NZF). This fund focuses on maintaining steady higher yields and is trading at a discount to net asset value of 11.29%. It yields 5.93%, which is a taxable equivalent yield of 9.12%.
And to round out our basket of municipal bonds, buy the Nuveen AMT-Fee Municipal Credit Income Fund (NVG). This fund has a particular added benefit beyond the focus on current income, as it buys municipal bonds that are exempt from the Alternative Minimum Tax (AMT) that can hit higher-income taxpayers. It is trading at a discount to net asset value by 12.73% and has a yield of 5.82% which means after tax it yields 8.95%.
In addition, as I noted above, these yields do not include the Christmas bonus payouts, which further boost the returns.
So, why the discounts? Closed-end funds come to the market in initial public offerings (IPOs), just like stocks. Fund companies make their pitches, sell shares and raise a set amount of capital to invest. This allows fund managers to avoid the fund churn that plagues open-end funds, which have to deal with daily inflows and outflows (and therefore redemptions) of investment.
Closed-end investors get stability and cost savings, and management can afford to take a longer view on the market. They can also use leverage to better manage portfolios via varied approaches, including issuing preferred shares.
Just like common stocks, closed-end funds will be valued at premiums or discounts to book value (or net asset value, NAV). But closed-end funds are cleaner in how book is valued, unlike common stocks that can and do use varied accounting schemes that can muddle reported book values.
Closed-end funds just tote up their holdings’ market prices and subtract liabilities to pop out the NAV, which is easy for individual investors to see.
The key is to look at the underlying portfolios of the closed-end funds. All three have seen their market prices pummeled, particularly since September, when rate spike fears took hold. And with the stock market declines in October and November, investors are simply selling everything, with little thought and less analysis. However, all three have seen their net asset values increase, meaning the value proposition for each has improved drastically.
The bottom line is that at the current discounts, these three funds are all at huge margins that haven’t been seen since the liquidation of the markets in the fourth quarter of 2008. With average discounts for the past ten years at a mere 1% or so, the current discounts are way cheap.
This buys a lot of downside protection for the stock prices, even if I’m wrong for a while on closing the discount margins. And investors will get large monthly tax-free dividends along the way.