Municipal CEF Update: High Yields And Wide Discounts

seekingalpha2024-06-14

Municipal CEFs have seen distribution hikes in response to activist attacks, aiming to tighten discounts and attract additional demand.Municipal bonds offer attractive valuations, high tax exemption ...

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Muni CEFs have gone through a whirlwind of distribution changes over the last couple of months, with many managers rushing through sizable and repeated distribution hikes. As we have discussed a number of times, this has mostly been in response to CEF activist attacks on the sector. Higher distributions tend to tighten discounts, and this is what the CEF managers are betting on to ward off the activists. Ever since longer-term rates backed up significantly over 2022 and credit spreads tightened, we have had a positive stance on municipal bonds. The recent distribution hikes by CEF managers have added a new tactical element where we expect muni CEF discounts to outperform, i.e. widen less relative to other sectors in a drawdown or tighten in a stable market environment. This combination of supportive strategic and tactical factors has led us to add to our muni CEF holdings in our Municipal Income Portfolio, which we discuss in more detail below. Positive Tactical Considerations Apart from the positive strategic factors favoring municipal bonds, there are two new tactical considerations as well. First, is the fact that, historically, returns are positive between Memorial Day and Election Day with a median return of 2.3% over this period from 1993 (and 3.1% in a General Election year) with BBB returns stronger than AAA/AA returns. The second tactical aspect has to do with the fact that many muni CEF current yields are now competitive with other CEF sectors, having yields of 7-8%, and significantly higher on a tax-equivalent basis, particularly for higher-rate taxpayers. Systematic Income Naturally, much of this yield (about half for the higher-yielding funds) is going to be ROC however it can still do the job as far as discount tightening as it is likely to generate additional demand, pulling investor capital from taxable sectors. This capital reallocation is likely to benefit higher-yielding funds in the sector. Systematic Income On the fundamentals side, things look pretty good. Upgrades continue to outpace downgrades. Median year-on-year tax collection growth came in at +1.5% through April, with personal income collections at +2%. BOA Valuations Are Overall Positive for Munis Municipal credit spreads remain near rock-bottom levels. This picture of tight spreads is similar to what we are seeing across the entire credit market, whether corporate bonds, loans or private lending. BOA Although spreads are tight, nominal and real yields are relatively high. This argues for an allocation to longer-duration assets such as munis despite an inverted yield curve, while tight spreads also argue for an allocation to higher-quality assets like munis as they tend to be more resilient during drawdowns. FRED High longer-term nominal yields translate into a higher tax exemption value for municipal bonds, or the difference between the municipal yield and its tax-equivalent value. This also makes municipal bonds relatively attractive versus their taxable, e.g. corporate bond counterparts. BOA The risk to credit assets is highly asymmetric from today's starting points. We could certainly see a small further grinding tighter of spreads, however, any large move in spreads is going to be wider, driving prices lower. Municipal bonds, by virtue of their relatively high quality, will tend to see less spread widening than lower-quality assets. This is because moves in spreads are roughly proportional. Securities with wide spreads, i.e. lower-quality high-yield corporate bonds typically see larger spreads moves than higher-quality securities like most municipal bonds. For example, a bond trading at a spread of 4% today could easily see a spread move to 8% while a municipal bond trading with a spread of 0.5% could see its spread widen to 1%. This is why higher-quality assets like municipal bonds are attractive assets to hold when credit spreads are tight. These assets tend to hold in much better during credit drawdowns, allowing investors to reallocate capital into higher-yield assets that suffer large price drawdowns. The second attractive feature of municipal bonds in the current environment has to do with their longer-duration profile. We find it particularly attractive to pair municipal bonds with floating-rate assets such as private lending assets like BDCs. In a typical macro shock, we tend to see longer-term rates fall and credit spreads rise. The longer-duration profile of municipal bonds often means they outperform other credit alternatives during drawdowns. Recent Distribution Moves As we have discussed a number of times in our CEF Weeklies, various muni CEF managers have substantially hiked the distributions on their CEFs, sometimes several times over a short period. Earlier this week, Nuveen delivered another series of distribution hikes, this time hiking many of its taxable funds as well. An example of this is shown below for the Nuveen Quality Municipal Income Fund (NAD). The fund's distribution has nearly doubled in just over half a year, from $0.038 to $0.755. The picture is similar for many other municipal funds from Nuveen as well as other managers. Nuveen It's important to stress that none of these hikes are for reasons of net income. In other words, these funds are not hiking because their net income is increasing. Municipal CEFs have fixed-rate assets and floating-rate liabilities, the latter of which are anchored off short-term rates like the SIFMA index - an index of 7-day investment-grade municipal variable-rate tax-exempt securities. Although the SIFMA index is volatile, it has basically range-traded over the last year - the direct outcome of the fact that the Fed policy rate has been on hold over this time. Bloomberg Fixed-rate assets combined with stable leverage costs explains why NAD net income has been flat. Eventually, we expect municipal CEF net income to move higher as the Fed cuts rates, but it is likely to take some time. Systematic Income CEF Tool The distribution hikes have, instead, reflected CEF activism in the sector, particularly in the case of municipal CEFs, something we have discussed over the last several months. Wide municipal CEF discounts remain attractive targets for activists. Systematic Income Typically, higher distributions are associated with tighter discounts, all else equal. Therefore, the hope of CEF managers is that higher distribution rates will tighten discounts and allow CEF activists to move on to other targets. So far, this has not worked, as municipal CEF discounts remain wide. However, the new much higher yields are more likely to attract additional demand from investors who don't normally hold municipal CEFs or from investors who normally hold municipal open-end funds. In our view, the risk to discounts is asymmetric - the next 5% move is likely to be due to tighter discounts rather than wider discounts. Our Portfolio Moves Based on these recent developments, we made a number of moves across both our tax-exempt and taxable portfolios. Specifically, we added positions in CEFs whose distributions were recently raised and which continue to trade at relatively wide discounts by rotating from open-end funds, taxable funds and muni CEFs that have not hiked their distributions or those that trade at relatively wide discounts. All the funds with added positions are strong performers in the sector. One new position is in the Western Asset Managed Municipals Fund (MMU). The fund's allocation profile is fairly typical of the sector, with the bulk in AA/A - rated bonds. Its duration is 8.3 years and lit has leverage of 31%. MMU trades at a 12.8% discount and 6.5% current yield. We also upsized positions in two Nuveen CEFs: the Nuveen Quality Municipal Income Fund (NAD) and the Nuveen Municipal Credit Income Fund (NZF), with the latter having a crossover credit flavor at 37% in unrated / sub-investment-grade bonds. NAD trades at a 7.9% current yield and 11.6% discount, while NZF trades at a 7.85% current yield and an 11.4% discount. Takeaways We continue to like the broader municipal bond sector for several reasons. One, high nominal and real yields suggest relatively strong returns going forward, given the historic correlation between starting yields and forward returns. PIMCO Two, credit markets remain very expensive with high-yield corporate bond spreads trading at ultra-low levels as shown below. If we see an unexpected macro shock and a back-up in credit spreads, municipal bonds are very likely to outperform higher-yielding credit securities such as corporate bonds and loans due to their higher-quality and longer duration profile. FRED  Finally, we see some municipal CEFs as tactically attractive due to large recent distribution hikes. Such high yields, though not directly supported by net income, are more likely to draw in additional demand, likely pushing discounts tighter.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.30.0","shortVersion":"4.30.0","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2443620172"}