TOM BUTCHER: I’m here with Paul Mazzilli, Senior Advisor to S-Network Global Indexes. ETF providers often seek to partner with innovative third-party index developers like S-Network. Using his extensive knowledge of the closed-end fund market, Paul was instrumental in the development of the S-Network Municipal Bond Closed-End Fund Index.
Paul, why may municipal bond closed-end funds be attractive for investors right now?
PAUL MAZZILLI:There are three attractive aspects of municipal closed-end funds, all of which are working together right now.
- As closed-end fund, they have a set investment, they’re run by professional managers, and since they don’t having assets come in and out like an open-end mutual fund, they can buy less-liquid, higher-yielding securities like private placements, non-rated bonds, and they’re not forced to sell bonds when people are seeking out liquidity.
- A unique aspect of municipal closed-end funds. They have the ability to leverage. When a closed-end fund leverages, it will borrow against its own assets and buy more bonds. Here is a simple example: For a $100 million closed-end fund, the most its allowed to borrow is one-third leverage. It can borrow $50 million and buy another $50 million of bonds. The $100 million in assets becomes $150 million invested. If the underlying bonds are yielding 4%, the leveraged fund would yield 6%, approximately, before any incremental costs. You get almost a 50% increase given this ability to leverage one third.
- The final thing is that after closed-end funds are issued, they trade as stocks in the marketplace. Based on demand and supply, they can trade rich to their value [at a premium], or they can trade cheap to their value [at a discount]. Right now, they’re selling historically cheap at about a 10% average discount. The 25-year average discount is approximately 2%. So when you’re selling at a 10% discount, if you’re buying a dollar of assets for $0.90, if you had an asset yielding 10%, you’re actually getting an 11.1% yield on the money you’re putting up.
This fact that they’re trading at a discount is happening right now because investors are fearful of the Fed raising rates. They are fearful of the equity markets, they’ve been raising cash since they’ve traded stocks, they’re selling them, they’re not looking at the underlying value, and it’s created a real buying opportunity. The discount has one other final advantage: If bonds were to sell off, but you’re buying at a 10% discount and it goes to a 5% discount, you actually could have a capital gain, even though the underlying bonds sell off.
BUTCHER: Is the prospect of debt restructuring in Puerto Rico going to have any impact on municipal bond closed-end funds?
MAZZILLI: Very good question. I think there are two different aspects. First, what does Puerto Rico do to the general municipal bond market? It is a significant issuer. It could have some impact in terms of how bonds trade. I personally believe a lot of that is already reflected in the market. Second is, what does it do to our index of municipal closed-end funds [S-Network Municipal Bond Closed-End Fund Index, CEFMX]? Our index currently has a very low exposure of about 0.43% to Puerto Rico. And that comes from two reasons. One: municipal closed-end funds tend to buy higher-quality funds, which would exclude Puerto Rico right now, or in the past. Two, we buy only national municipal closed-end funds, or our index represents only national municipal closed-end funds. And the national funds buy very little Puerto Rico exposure because they have a lot of other ways to diversify.
BUTCHER: Paul, thank you very much for joining me today.