At this time, I believe the underlying market for municipal bonds looks favorable. Federal spending cuts, in my opinion, are not likely to affect municipal credits, and the U.S. economy continues to grow at a moderate rate, which is good for municipals. In addition, I believe last year’s tax rate increase for the wealthiest Americans and the likelihood of further rate hikes, or losses of deductions, may help support the market for municipal bonds. However, as the market outlook appears better so far in 2014 compared to last year, closed-end funds (CEFs) investing in municipal bonds continue to sell at historically wide discounts.
Buying CEFs at discounts, in turn, tends to increase the yield an investor may get on the market price. (See example below.) I believe that discount is likely to narrow over the next few months as the underlying municipal market stabilizes. Historically, as the market stabilizes, CEF discounts have tended to shrink as investors chased the potentially higher yields provided by the discounts.
“Yield Enhancement” and Absolute Discounts
Source: Morningstar. Past performance is not an indication, or guarantee, of future results. Hypothetical or model performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading and accordingly, may have under- or over-compensated for the impact, if any, of certain market factors, such as market disruptions and lack of liquidity. In addition, hypothetical trading does not involve financial risk and no hypothetical trading record can completely account for the impact of financial risk in actual trading. Simulated performance is subject to the fact that it is designed with the benefit of hindsight. The actual performance of the ETP may vary significantly from the hypothetical data.
In my opinion, a good barometer for the market of CEFs investing in municipal bonds is the S-Network Municipal Bond Closed-End Fund Index, an index of 84 municipal bond CEFs (as of 3/31/14) that are selected and weighted using a proprietary rules-based methodology. The index uses a value approach to take advantage of pricing inefficiencies related to CEFs trading at discounts to their NAV. Unlike most ETF indices, which are market-cap weighted, this index weights initially by NAV so as not to give a greater weight to CEFs selling at richer valuations.
It then tiers CEFs to overweight those selling at higher discounts and to underweight CEFs selling at lower discounts or premiums. This value approach is designed to increase the allocation to undervalued CEFs during quarterly index rebalancing and reduce exposure to more richly valued CEFs. On average, since its inception on June 3, 2011, the index has an average discount of 2% to 4% greater than that of its overall constituents.