Municipal CEF Market Update: Much Improved Valuation Profile
This article was first published to Systematic Income subscribers and free trials on February 22.
In our previous municipal sector update, we were concerned about the level of future returns given low underlying bond yields, costly CEF rebates and rising leverage costs. What a difference a month and a half makes – since then the CEF sector has fallen around 10%. As staunch value investors, we think this is a very good thing as the sector now offers a much more attractive point for new capital.
In this update, we discuss the improving valuation profile of the sector, review the fundamentals and highlight the opportunities ahead.
A better time to invest
We view the tax-exempt municipal bond sector as one of the most attractive parts of the broader income space, particularly in the CEF format for the following reasons.
First, as CEF rebates have expanded significantly, corporate credit spreads haven’t budged much. We can see this in the following chart which plots corporate credit spreads (x-axis) and credit CEF sector haircuts (y-axis). What it shows is that haircuts are back in the middle part of their 5-year range while credit spreads remain quite tight.
What this suggests is that the tilt towards higher quality assets like municipal bonds may make sense in this environment since the impact of any pronounced widening of credit spreads will be relatively small on these higher quality assets. .
Second, tax-exempt rebate valuations look attractive in the expanded space of the CEF. We can see it from the following excerpt from the CEF Tool service. Municipal sector rebates are, on average, larger than the median in absolute terms and seem cheap in relative terms. For example, the national percentile of tax-exempt rebates is currently only 24%, meaning that it has only exceeded the current level of 5.45% less than a quarter of the time over the past few years. past 5 years, while the median percentile of industry rebates is 48%. it is quite close to the middle part of its historical range.
Third, the the municipal sector underperformed Treasuries year to date. Year-to-date, longer-term yields in the investment grade and high-yield sub-sectors have risen nearly 0.8%, nearly double the yield on the 10-year Treasury. According to Bank of America, AAA munis value a 10-year Treasury yield of 2.5% over existing tax rates. The Treasury/Muni ratios have corrected and moved into the high range of 2019. This provides a significant margin of safety as the 10-year Treasury yield remains below 2% at the moment.
Ultimately, the fundamentals remain attractive. Median year-over-year growth in tax collections is robust, with median collections in January up 26%. Rating actions have leveled off even in the relatively stressed healthcare sector, with upgrades now outpacing downgrades. A number of state governors have proposed tax cuts, illustrating the strong fiscal positions of many states – for example, Califnora is forecasting a $45 billion surplus while New York erased its projected deficits.
Let’s be frank about the risks
A number of risks remain for investors in the sector.
One of the main headwinds is that CEF leverage costs have started to rise. Tax-exempt leverage costs are typically anchored to the SIFMA rate, much like taxable fund costs are anchored to Libor. And just as Libor recently rose in response to the Fed’s price hike in March, so has SIFMA.
We are still expecting a significant drop in distribution coverage figures for the municipal sector. The average level of hedging for the sector has gradually declined over the past year, despite a number of funds having already reduced their distribution levels (which should normally support hedging, all else being equal). We expect this trend to accelerate once the Fed starts raising rates.
The chart below shows the trailing 12-month distribution trend of the municipal tax-exempt CEF sector for the past 10 years, starting at 100 with our annotations.
The main finding of the chart is that changes in short-term rates largely explain the movements in distributions from the tax-exempt sector. For example, between 2012 and 2016, the Fed kept short-term rates close to zero. Then the Fed began raising rates in late 2015, with the upper limit ending at 2.5% at the end of 2018. During this period, the distribution trend accelerated downward. Then, in 2020, the Fed cut the policy rate sharply to zero, leading to increased sector distributions which have now leveled off somewhat.
What this means going forward is that we expect the sector to largely reverse its previous increase in revenue and distribution, resulting in a number of cuts. In our view, this is the price of entry into the CEF sector and it is offset by its more attractive valuation. Investors who want to avoid distribution cuts driven by leverage costs may want to stick with open-end funds or non-leveraged CEFs.
What we do
We recently took advantage of the dislocation in the CEF sector to switch from our “dry powder” allocation of open ended funds and CEF futures to perpetual CEFs.
Year-to-date, open-ended funds such as ETFs and mutual funds have outperformed the broader CEF sector, as shown in the chart excerpt from our Funds Tool service below.
Forward CEFs also outperformed perpetual CEFs – the chart below shows how forward CEF discounts held up a bit better than their perpetual counterparts in the tax-exempt sector. This is something we have discussed many times in the past and it is a feature of the CEF market that continues to influence our allocation position.
In terms of credit profile, we find that the broader investment grade sub-sector offers a bit more attractive valuation.
This is best seen in the following chart which shows the differential between the yields of high yield and investment grade tax exempt bonds, showing that high yield munis offer a historically weak yield recovery compared to investment grade bonds. superior (the ratio of the returns of the two sub-sectors shows a similar picture).
That’s why the majority of our rotation has been in the quality investing space.
More specifically, we added to the Eaton Vance Municipal Income Trust (EVN) and BlackRock MuniYield III Quality Fund (MYI), among other funds.
EVN is trading at an 8.3% discount (vs. 5.4% industry average) and a current yield of 4.67%.
EVN has a 79% allocation to investment grade rated bonds with an average duration of 7.7. Sub-sector overweights are in GO, transportation and hospital bonds.
EVN has outperformed the industry in terms of total net asset value over the past 3 and 5 years.
The coverage of the distribution remains above 100% with a significant positive UNII amount.
The fund’s valuation has recently depreciated against the sector which we believe offers an attractive entry point.
MYI has an investment grade allocation of 89% with a focus on the transportation, GO and healthcare sub-sectors. It is trading at a discount of 7.9% and a current yield of 4.67%. MYI generated a 5-year total net asset value return of 4.6% or 0.2% above the industry average. Coverage has declined somewhat – a very common trend in the wider industry, however, UNII remains at a relatively high level.
Elsewhere, we continue to find value in short term high yield munis such as the Nuveen Short Duration HY Municipal Bond Fund (NVHAX) given the steep flattening of the yield curve. This sub-sector offers a lower duration option compared to the broader municipal sector as well as a higher return.
NVHAX posted very impressive returns – on par with CEFs despite its lower duration position (equivalent to holding low-yielding securities due to the sloping nature of the yield curve) and with little effect of the sink. And unlike its sister fund NHMAX, it remains open to new investors.
Take away food
The tax-exempt sector remains an attractive location for new capital. Rising Treasury yields are an obvious risk and the rising cost of leverage will be a headwind for CEF earnings, however, in our view, the much improved valuation picture compared to 2021 is sufficient to make the sector attractive. Strong fundamentals, favorable supply and a higher quality profile in an environment where lower quality assets remain expensive add to the investment case.