Given the likely continuation of the record low fixed income yield environment for the foreseeable future, potential periods of heightened, future stock market volatility and attractive current yields versus comparable taxable investments, municipal bonds and municipal bond-oriented investment strategies, including closed-end funds (CEFs), have been in high demand of late. For example, as you will see from the table below, all U.S. Traded Tax-Free National Muni Bond CEFs are now trading, on average, above their 10 year average premium/discount. This has not been the case in the last two years.
Source: Wells Fargo Advisors/Morningstar as of April 14, 2016.
In addition, with respect to municipal bond-focused mutual funds, U.S. Municipal bond funds recently posted their 28th consecutive week of inflows. Consider the mutual fund flow information for Municipal Bond funds relative to Taxable Bond funds below from the Investment Company Institute’s (ICI) Trends in Mutual Fund Investing report for the first two months of 2016.
Overall, the strong demand for, and low underlying supply of, municipal bonds have kept prices high and yields relatively low during the first quarter, yet I would anticipate demand remaining high for municipal bond-oriented investment strategies for the balance of 2016. As a result, for those interested in adding, or increasing, allocations to municipal bonds through CEFs to their client portfolios, the following overview of the municipal bond CEFs may prove helpful.
At present, there are 176 closed-end funds in the Tax-Free Income category outstanding across 19 different strategies; some national and some state specific, according to CEFConnect.com.
Since CEFs contain their own unique set or risk considerations, including but not limited to the utilization of leverage, it is critical in my view to employ a comprehensive set of selection criteria beyond just looking for those CEFs that have the highest current yield and/or are trading at the deepest discount relative to their own net asset value (NAV). In this regard, some of the screening criteria that we consider at SmartTrust® when selecting municipal CEFs for our applicable unit investment trust (UIT) strategies include, but is not limited to, the following:
• Market Cap & Liquidity – measured by total net assets, in U.S. dollars, and average trading volumes of the CEF. We generally look for CEFs with total net assets of $100mm or greater, while also giving consideration for average trading volume.
• Distribution Rate – this is the current distribution rate, or yield, of the CEF and is a measure of the current annualized distribution amount divided by the current price – not the NAV.
• Distribution Amount – most current cash distribution amount per share. We are only interested in looking at regular income distributions and disregard returns of principal, special (i.e. non-regular) distributions, short term capital gains and long term capital gains.
• Earnings per Share (EPS) – this is the most current amount that the CEF earned per share. We generally exclude those CEFs with negative earnings per share.
• Earnings/Distribution Coverage Ratio – this ratio compares current earnings to current monthly distribution amounts where ratios over 100% indicate that the CEF is “over-covered” from an earnings/distribution standpoint and ratios under 100% indicate that the CEF is “under-covered” from an earnings/distribution standpoint. We prefer CEFs that have a high Earnings/Distribution Coverage Ratio.
• Undistributed Net Investment Income (UNII) – the life-to-date balance of a fund’s net investment income less distributions of net investment income. UNII appears in shareholder reports as a line item on a fund’s statement of changes in net assets. We consider UNII as a cash buffer or a cash reserve to a CEF portfolio. We typically do not consider CEFs with negative UNII balances.
• UNII/Distribution Coverage Ratio – this ratio compares current UNII balances to current monthly distribution amounts to determine how many months of distribution coverage are covered by the CEF’s UNII balance.
• Premium / (Discount) –the amount which a closed-end fund market price exceeds (premium) or is less than (discount) the net asset value (NAV) of that CEF. We contend that a CEF trading at a premium does not necessarily mean it is overvalued and a CEF trading at a discount is not necessarily undervalued. There is nothing written in stone that states that a closed-end fund (CEF) ever has to trade at its net asset value.
• 52 Week Average Premium / (Discount) – to help gauge the relative value of the current premium / (discount) of a given CEF, we compare the current to premium / (discount to the 52 week average premium / (discount). Such comparisons are done not only for the CEF itself but also in relation to their category/strategy. For example, CEFs trading below their 52 week averages represent greater relative value to us than those CEFs trading above their 52 week averages.
• Effective Leverage (and type of leverage employed) – total economic leverage exposure of the CEF and includes structural leverage, which is calculated using leverage created by a fund’s preferred shares or debt borrowings by the fund, as well as 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 are still currently employing some form of leverage to enhance their portfolio yields and take advantage of low relative borrowing costs. For example, approximately 97% of all tax-free income CEFs currently employ some form of leverage. Recognizing that portfolio leverage may increase the volatility of a given CEF and leverage itself can provide less value when short-term rates approach or exceed long-term rates, we pay careful attention to the type and amount of leverage that each CEF strategy employs, especially as we are now within what is likely to be a protracted period of gradually rising interest rates.
• Expense Ratio – it is important to be cognizant of the effect that the underlying CEF expense ratios have on the overall portfolio performance of the strategy.
• Credit Quality – most CEF sponsors report the credit quality breakdown of the underlying bond holdings within their portfolios at different reporting periods.
• Maturity – most CEF sponsors report the maturities of the underlying bond holdings within their portfolios at different reporting periods.
• Option Adjusted Duration (OAD) – while all CEF sponsors do not necessarily report the OAD of the underlying bond holdings within their portfolios at different reporting periods, financial software providers, such as Bloomberg, do calculate and provide this interest rate sensitivity based information.
• AMT Percentage – most CEF sponsors report the AMT percentages of the underlying bond holdings within their portfolios at different reporting periods. This information may be helpful for portfolios allocations to high new worth clients who are within a higher tax bracket.
• % of Portfolio Pre-refunded – most CEF sponsors report the percentage of their portfolios that are pre-refunded related to the underlying bond holdings within their portfolios at different reporting periods. We generally look favorably on pre-refunded bonds. To appreciate our perspective, it is necessary to understand how pre-refunded bonds work. Pre-refunded bonds are issued to fund another callable municipal bond, where the issuer of the municipal bond actually decides to exercise its right to buy its bonds back before the bond’s scheduled maturity date. The proceeds from the issue of the lower yield and/or longer maturing pre-refunding bond will usually be invested in U.S. Treasury bills until the scheduled call date of the original bond issue occurs, thereby reducing the credit risk of the original bond issuance.
While no screening criteria can guarantee the success of a selected investment strategy, I believe that the multi-factor approach described above can be helpful in uncovering municipal CEFs that strive to pay high, sustainable levels of tax-free income, and provide for total return potential, over the life of each CEF investment strategy.
Disclosure: Hennion & Walsh is the sponsor of SmartTrust® Unit Investment Trusts (UITs). For more information on SmartTrust® UITs, please visit www.smarttrustuit.com. The overview above is for informational purposes and is not an offer to sell or a solicitation of an offer to buy any SmartTrust® UITs. Investors should consider the Trust’s investment objective, risks, charges and expenses carefully before investing. The prospectus contains this and other information relevant to an investment in the Trust and investors should read the prospectus carefully before they invest.