Efficiency, Diversity, and Yield

I continue to be attracted to municipal bond closed-end funds (CEFs) given their compelling tax-exempt yields and believe that the Market Vectors CEF Municipal Income ETF (XMPT) is an efficient way to get diversified access to this market1. XMPT tracks the S-Network Municipal Bond Closed-End Fund Index (CEFMX) and, for those in the highest tax-bracket, is currently among the highest yielding ETFs that provide exposure to the municipal bond CEF market. Many buyers of CEFs may not get proper diversification or have the time to research individual CEFs. As a fund-of-funds, XMPT seeks to provide diversification by asset, strategy, and active manager.

There have been significant changes in municipal CEF market prices over the past year. In much of 2012 and early 2013, these funds were selling at premiums to their net asset values (NAVs) as investors were attracted to their high tax-exempt yields and, in my opinion, were perhaps complacent about the conditions of the overall bond markets. In mid-2013, municipal bond CEFs had significant downward price movements as the multi-year rally in bonds finally came to an end and they began to sell at discounts to their NAVs. Fears about further drops in bond prices, in part, caused discounts to widen continually far beyond their historical averages.

I believe a number of factors contributed to this weakness in municipal bond CEFs in the second half of 2013. These included: rising U.S. Treasury yields, anticipation of potential municipal bond CEF dividend reductions, concerns over the federal tax-exempt status of municipal bonds, increasing municipal bond supply, and the downgrade of Puerto Rico by major rating agencies. Furthermore, given the strong performance of municipal CEFs over the past five years and their rich valuations, it is likely that the initial declines triggered more profit taking (realizing gains) by municipal CEF investors.

However, moving into 2014, the underlying market for municipal bonds appears to have stabilized and a recent $3.5 billion new issue by Puerto Rico has improved market sentiment. Puerto Rico is considered by many as the riskiest debt issuer in the $3.7 trillion U.S. municipal bond market. All three major rating agencies recently cut Puerto Rico’s credit rating to junk, citing low liquidity and persistent economic troubles. The territory has roughly $70 billion in outstanding debt and has endured nearly eight years of recession. Most U.S. CEFs investing in municipal bonds have very low exposure to Puerto Rico because they are diversified by state and avoid weaker credits. However, I see the ability of Puerto Rico to complete a large financing as good for the municipal bond market in general.

1A portion of the Fund’s dividends may be subject to federal, state, or local income taxes or may be subject to the federal alternative minimum tax (AMT).

MUNI NATION invited Paul Mazzilli, a leading ETF and closed-end fund analyst, to provide a three-part commentary on the state of the municipal closed-end fund market.