(Michael Sedacca, Rareview Capital) Quantitatively, there is the most fear priced into the municipal-bond closed-end fund sector in over a decade. If you own and plan to hold municipal bond closed-end funds over the medium-term, based on the relative value to municipal cash bonds, there is a compelling argument you should not sell them. Moreover, leading up to the first interest rate hike by the Federal Reserve in the coming weeks, there is a strong case that an allocation should be made to this sector.
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MUNICIPAL BOND CEF DISCOUNTS-TO-NAV
Municipal bond closed-end funds (“CEFs”) make up approximately one-third of all CEFs – they are the largest sector by far. Mechanically, their discount-to-NAV widens or narrows based on the change in their distribution yield. The largest marginal input in determining the distribution yield is the change in leverage costs. When leverage costs rise because of higher short-term borrowing rates, the distribution rate falls, and the discount-to-NAV widens. Conversely, when leverage costs fall because of lower short-term borrowing rates, the distribution rate rises, and the discount-to-NAV narrows. Therefore, municipal bond CEF discounts-to-NAV is the most straightforward to quantify of any fixed income sector because changes in interest rates explain ~99% of all movements in broad municipal bonds over the intermediate-term.
Occasionally, those discounts can widen in the short-term based on a high degree of fear in the marketplace. As a result of the fixed income market now pricing in 7-8 interest rate hikes in 2022, up from 3-4 hikes on December 31, 2021, we believe this is one of those times.
In response, municipal-bond CEF discounts in our target universe have widened to -11.30% from -3.88% on December 31, 2021. This -7.42% discount widening in the past six weeks is the fastest rate of change since the Great Financial Crisis.
A z-score is a measure of how far an asset has moved from the mean. Statistically, on a scale of +2.0 to -2.0, the absolute level of discounts has fallen from +0.6 to -1.7 z-score scores. To further put this in context, discount-to-NAV’s are in the 95%-percentile of cheapness.
DIVIDEND RATIO: MUNICIPAL BOND CEFS VS. CASH MUNICIPAL BONDS
In addition to analyzing discounts-to-NAV’s to measure the historical cheapness of the sector, we compare the annualized distribution yield of municipal bond CEFs to cash municipal bonds. The proxies we use are the S-Network Municipal Bond CEF Index (symbol: CEFMX) and the iShares National Muni Bond ETF (symbol: MUB).
The latest annualized distribution yield for CEFMX is 4.98% relative to MUB’s 1.69%, or 2.95 times greater.
Historically, this relative dividend ratio is 2.20-2.25 times greater than municipal cash bonds. Currently, at 2.95 times, this is the highest relative dividend ratio since the inception of the CEFMX Index! Said differently, the key determinant for owning municipal bond CEF’s during a Fed tightening cycle – their relative dividend yield – has the most attractive starting point since the Great Financial Crisis.
Note that at the end of the 2018 hiking cycle, when the yield curve inverted, the ratio fell below 2.0. The critical point is that even if the spread between funding and investment rates narrows, and the absolute dividend-per-share in municipal CEF’s declines, the ratio has a significant head-start if the Federal Reserve undertakes an aggressive interest rate hiking cycle.
MUNICIPAL BOND CEF DISTRIBUTIONS
As leverage costs rise, municipal bond CEF’s mechanically cut their distribution rates in-kind as stated above. Typically, distribution cuts in the municipal bond CEF sector are approximately 15% during a Fed hiking cycle. For example, if the monthly distribution for a municipal bond CEF were $0.07/share, it would decline to ~$0.06/share.
Today, for the CEFMX/MUB ratio to revert to its historical range, the average municipal bond CEF would need to cut its dividend by ~24.5%. This is substantially more than the normal ~15% distribution cuts over a Fed tightening cycle for the municipal bond CEF sector.
CONCLUSION
Quantitatively, there is the most fear priced into the municipal-bond closed-end fund sector in over a decade. If you own and plan to hold municipal bond closed-end funds over the medium-term, based on the relative value to municipal cash bonds, there is a compelling argument you should not sell them. Moreover, leading up to the first interest rate hike by the Federal Reserve in the coming weeks, there is a strong case that an allocation should be made to this sector.
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