In my Time to buy munis? post the other day I think I left out a couple of key elements in my desire to keep the post from becoming too long. As I said in my last paragraph, an even slightly aggressive income investor may want to look at muni closed-end funds as a way to take advantage of the muni sell off and collect some great yield at the same time. Great yield and a chance for capital appreciation – what’s not to like about that?
First, a closed-end fund is similar to a mutual fund except that it issues shares only one time (or only a few times at the most). These funds then trade on the exchanges just like any other stocks. So, there are no real fund inflow or redemption issues like there are in ordinary mutual funds. Second, they are allowed to use leverage. They can do this in several ways; through the issuance of auction rate securities, preferred shares, repo agreements, etc… The important point is that the leverage allows the manager to enhance returns (or destroy them). But for stodgy boring bonds, in particular government bonds, this can often be a very good thing for investors. Lastly, since the funds trade on exchanges they are subject to the supply/demand just like stocks so they often trade at either a premium or discount to their underlying value (referred to as NAV, net asset value). This creates yet another opportunity for investors. For more info on closed end funds I recommend two sites; CEF Connect and the CEF Association.
Lets take a look at the muni CEF space then. The big names in the muni CEF business are Blackrock, Eaton Vance, Nuveen, Invesco, and Pimco. Using the fund screener at CEF connect in search for National Muni CEFs gives quite a long list. Here is just a snapshot of the list.
In the list you can see the yield of the muni CEFs, the amount of leverage they are using, and the premium or discount to NAV that they are currently trading at. Lets take the second fund on the list as an example, NPI. It trades just about at its NAV and it yields 7.14%. That is 7.14% tax free. In a taxable account for an investor in the 25% marginal tax bracket, that is a tax equivalent yield of 9.52%! Compare that to some of the high yield taxable bond offerings like HYG (8.2%) or JNK (9.1%) which yield less and are trading at much lower spreads to treasuries than munis. In other words, high yield bonds are a bit expensive right now. Also, NPI has traded as low at a 6.8% discount to NAV and as high as a 3% premium to NAV so there is a chance for capital gains as well. So, if muni prices never recover you’re going to make 7.14% tax-free. Yes, there are risks, but how does the risk compare to other risks you would take or are taking to make 7% after tax?
One note here. I don’t see why anyone would buy any CEF at a premium to NAV. Just don’t do it. Its crazy. Take a look at PMF, Pimco Municipal Income. It trades at a 24% premium to NAV. Pimco must have some amazing marketing or investors don’t know what they’re doing. Caveat Emptor.
Just a couple of days ago I went through a similar analysis and opened a position in a muni CEF, NXZ. I liked the discount to NAV, its yield, and its track record. I’m looking to add to my position on weakness and also pick up some other muni CEFs.
In closing I want to point out a few tips for dealing with CEFs in general; again – don’t buy any CEFs at a premium to NAV, don’t buy CEFs at their IPO (that’s where the investment firms make big bucks off you), and use limit orders to trade CEFs due to their sometimes thin volume. With a few simple guidelines I think muni CEFs are offering a great risk reward trade-off right now.
Oh one more thing, I found this article, Battle of the Bond Girls, on the muni wars quite entertaining. Enjoy.
Disclosure: long NXZ