If there’s a day of reckoning on the horizon for municipal closed-end funds, the market hasn’t spotted it as investors continue to fork over a premium for the trusts.
The municipal closed-end fund sector has continued its upward march all year and become exceedingly expensive by some measures of value. They now routinely trade at a premium, instead of the once-customary discount.
The muni CEF industry returned 3.7% in August, according to a First Trust Advisors index tracking the sector.
The industry has returned 16.3% this year after delivering a 43% return in 2009.
Judging by the average fund premium to asset value, the sector is its most expensive in more than 10 years, according to Stifel Nicolaus analyst Alex Reiss.
“America’s love affair with yield continues to buoy closed-end income funds to lofty valuations,” Thomas J. Herzfeld Advisors wrote in its monthly report. “The question is, do the investors understand what they are buying?”
Closed-end funds are stocks representing ownership in a trust populated with an asset, such as state and local government debt.
Appreciation in these stocks derives from two factors: an increase in the value of the assets in the trust, or investors’ willingness to pay more per dollar of assets in the trust.
It appears that less than half of the municipal closed-end fund sector’s price appreciation this year is attributable to an increase in the value of municipal bonds themselves.
The average municipal bond price is up 4.2% in 2010, according to a Standard & Poor’s index tracking tax-exempt debt. The average municipal bond CEF’s price is up 11.2%.
That means returns have been driven less by the performance of the underlying trusts, and more by the market’s appetite for owning them.
Thomas J. Herzfeld suspects much of this appetite is coming from investors who don’t really know the difference.
As the firm put it, many of these investors “have little understanding of the potential risks of buying $1 worth of assets for $1.10, $1.20, or more.”
Herzfeld prefers to buy closed-end funds when they trade at less than $1 per $1 of assets — a “discount” in closed-end fund parlance. This used to be easier than it is today.
Leveraged closed-end municipal funds over the past 10 years have traded at an average discount of 3.75%, Reiss said.
Today, the average fund in the First Trust index trades at a weighted average premium of 2.6%.
Of the 94 funds in the First Trust Advisors municipal index, 76 now trade at a premium.
The $487.7 million PIMCO Municipal Income Fund’s net assets total $12.34 per share, and the stock trades at $14.87 — a premium of 20.5%.
Every dime of Herzfeld’s $450,000 portfolio devoted to muni CEFs is sitting in cash.
Maury Fertig, chief investment officer at Relative Value Partners, is also avoiding closed-end funds at these prices.
“We know what can happen in the event of a shock to the system,” he said. “Which at some point we’ll have.”
What does Fertig mean by a “shock to the system”?
Leveraged closed-end funds often enjoy superior performance in good markets and get destroyed in bad markets. In 2008, closed-end municipal funds plunged 26.4%. Buying funds at a premium leaves investors particularly vulnerable, Herzfeld said.
The same structure that juices income when short-term rates are low and the yield curve is steep leaves CEFs susceptible to a spike in rates.
Higher interest rates would raise funds’ borrowing costs as well as whack the value of the bonds held in their trusts.
The propensity among unsophisticated new buyers of closed-end funds to sell off all their holdings when things get bad could further pressure prices, Fertig said.
“We wonder if [investors] realize just how much they may be overpaying,” Herzfeld said in its report. “Or, will they have a rude awakening when a dividend cut or market downturn brings valuations back in line with underlying value?”
Premiums notwithstanding, Fertig concedes that the demand for municipal closed-end funds is understandable. It is driven by a craving for yield.
The weighted average yield on the 94 municipal closed-end funds in the First Trust index is more than 6%.
A tax-free yield of 6% is compelling at a time when 30-year single-A rated municipal bonds are yielding 4.3%, according to Municipal Market Data.
CEFs are able to offer these kinds of yields because of leverage. Many funds borrow short-term money and use it to buy additional bonds for their trusts.
The income generated by the long-term bonds in excess of the borrowing costs on the short-term debt is gravy for shareholders.
Because most closed-end funds’ short-term debt is pegged to the London Interbank Offered Rate, which is around 0.3%, the leverage is enhancing the income generated by these trusts.
“The income component of municipal closed-end fund investing is still intact,” Reiss said. “Leverage costs remain low and will, in our opinion, stay that way for a while. … We believe the dividends of most leveraged municipal bond funds will remain stable for the foreseeable future.”
Reiss recommends buying some of these funds for their income. Just don’t expect them to increase in price.
He has “Buy” ratings on the Nuveen Insured Municipal Opportunity Fund, the Invesco Insured Municipal Income Trust, and Invesco Quality Municipal Securities.
Municipal closed-end funds manage $80 billion, according to the Investment Company Institute.
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