Muni CEF April 2022 Update: No Capitulation Yet, Cuts Have Begun (2023)

(This article was first published for members ofperformance huntingon April 12, 2022. All data included here corresponds to that date).

We remain cautious on municipal securities and price action today, along with rising long-term interest rates.and curve reversals - is indicative of that attitude. Also, the sector's valuation is not where we would need it to be to cushion some of the larger risks and headwinds.

In this report, we discuss how to think about municipal space for long-term income-oriented investors. Some investors view municipal investments as a short-term trade, but they're not cut out for it. We discuss how to frame these investments in your portfolio.

The market is still a precarious market and I am still activea wait and see attitude. I've done several trades because you can add significant value by reaping tax losses, but as far as new money goes, that's on the sidelines.

Main purchases by valuation and distribution stability:

(1) main term defined by MacKay Muni Opp (mmd), yield 5.72%, discount -5.6%.

(2) Nuveen AMT - Free Muni Credit (ANE), yield 4.97%, discount -8.8%

(3) BNY Mellon Strategic Township (LEÓN), yield 5.12%, discount -8.6%

(4) Blackrock MuniChaleco (MVF), yield 5.16%, discount -10.5%

(5) County of Eaton Vance (EVN), yield 5.05%, discount -9.04%

(6) Invesco PA Value Muni (VPV), profitability 5.02%, discount -13.3%

(7) PIMCO municipal income (FMP), yield 5.7%, premium +0.2%

The state of the Muni market today

Municipal bonds are very stable investments in most years. However, there is the occasional year when interest rate expectations are unexpectedly higher than the market had anticipated. We last saw it in late 2018 and before that in 2013. These are usually good years to buy.

We enter 2022 on very strong foundations following the latest round of fiscal stimulus that allocated significant resources to state and local council budgets. Defaults are not an issue, so we've been pushing high-yield munis since last year.

However, rising interest rates caused municipal bond performance to fall to its worst performance in 40 years. Through March 31, the sector posted a total return of -6.4% as municipal cash flows remain negative.

It should be noted that the municipal market and interest rates do not move in perfect correlation. This is primarily because municipal bonds are an illiquid asset class with less than 2% of outstanding bonds traded on any given day. For example, very few bonds are accurately modified to fully reflect changes in the interest rate market.

The chart below shows that even through a long history of changes in Federal Reserve interest rate policy through different market cycles, municipal bonds have consistently generated positive returns. One contributing factor is that tax exemption is valuable in all tax and rate environments for many types of investors. The chart shows that, looking back over the last 26 years, municipal bonds have had negative returns in only four of those years. During those periods, both interest and credits worked together to reduce all fixed income, unlike the current situation.

Outflows continue to be the name of the game with 7 consecutive weeks of $2.0 billion in money flowing from space in the last week alone. More than $108 billion in market value has been lost since the start of the year. Bloomberg noted that the number of bonds being offered (meaning they are trying to sell) was $2.1 billion, a level not seen since the start of the pandemic.

30-year AAA Munis are trading at 106% of the same US Treasury yield, the highest since late 2020. That ratio bottomed out at 67% in June 2021.

How far can rates go up?

Real interest rates are seriously negative, which means that the sky is really the limit on how much interest rates can go up in the long run. But in reality, thereesa cap as inflation should come down a bit and most believe inflation will ease as economic growth slows, supply problems are rectified and the stimulant effects of the past two years fade.

The trajectory of inflation will be the big unknown this year. It will likely dictate a lot of what happens in risky assets, as it will largely determine what the Fed does with regard to interest rates and balance sheet reduction.

Much of what happens to the 10-year rate in the next nine months also depends on economic growth. Projections for 2022 are much lower than the 6.9% GDP growth we saw in 2021. That +6.9% growth was the fastest since 1984. Most expect GDP to fall below 3% throughout 2022.

The dispersion of the expected results for this year for both GDP growth and 10-year rates is exceptionally wide, demonstrating the degree of uncertainty. The key is how quickly the US can shake off the negative effects of supply chain problems and high inflation. We've seen some signs of improvement lately, but only minor improvements. Consumer spending hasn't budged at all so far, but that's likely to start to change.

The chart below shows how the market has consistently underestimated its inflation forecasts. If this continues, the market may also be underestimating interest rate spikes.

Muni's CEFs are affected, but the discounts aren't too cheap

In a recent article titled "Is it time to add to the CEF or not?The first point of several was to buy the NAV, not the discount. Before considering the discount as cheap and an opportunity, evaluate the potential return of the NAV over the next two years.

Even if there is a large margin of safety at a deep discount, if the NAV falls, the discount is not of much use. As I wrote:

If you buy a fund that is heavily discounted, but the NAV is in free fall, the discount doesn't really matter. Sure, you get a small percentage of extra buffering and some extra performance, but that can quickly disappear in a declining NAV environment like the one we're living in.

On Wednesday March 30, I observed that the muni CEF space was trading at discounts of around -4.8%, which was slightly tighter than the long-term average. In other words, about 46% of the time, the discounts were more stringent. To me, that's not a level that screams a large margin of safety.

In previous environments with sky-high rates, like 2018 and 2013 before, the percentage of times discounts were tighter was much higher. At the end of 2018, the number even reached 99%. In other words, in almost all previous cases, since 1996, the discount was much smaller.

I used the following chart in that note which shows that fed funds are rising 3 times faster this tightening cycle (or at least expected to be) compared to 2018. If interest rates are rising faster and rates in the long run they're rising faster too (but just as flat) I was surprised that we haven't really seen the muni discounts explode.

The discounts reach a minimum of around -6.5% and are no longer sold out. Again, I'm surprised by this given the rates. You can see the previous rate hike environment on the far left of the chart below (beginning January 1, 2019). The discounts were broader than we saw in the depths of the Covid recession.

I have been waiting for those discounts to expand or break above the black line on the chart above.

Update: Since I wrote the above, municipal discounts have been expanded significantly. We're now in the 84th percentile. However, I'll wait for the 90th to be interested in adding new money to the space. Not only that, but I should be comfortable thinking that long-term interest rates were near the top.

NAVs are too weak to go in here

The 10-year bond yield recently hit 2.77%, driving down the price of anything with a duration. The inverse relationship between rates and prices depresses the NAV of all municipal bond funds.

The following graph showsNuveen AMT Free Muni Inc (ANE), the term trustObjective BlackRock Municipal 2030 (BTT), and an unleveraged fund,Western Assets Municipal Inc (MHF). First, you can see the effect of leverage on NAV performance. However, we can also see that leverage is NOT the only reason these NAVs are low.

As the 10-year note continues to rise, the NAV will continue to fall. I have seen comments about SA that the continued decline in the value of these municipal funds will stop if they replace lower yielding coupons with higher yielding coupons. That is incorrect. Coupons go up. Yes. But that won't come close to offsetting maturity or interest rate effects.

Retail investors bought munis last year at 1% yield and don't want to touch them now at 2-3% yield. We always see this in all parts of the market, as external factors drive investors away. The opposite in me wants to charge here, but I waitimpatient.

For now, with the Fed in extremely aggressive rate-raising mode, and the 10-year note looking set to go higher. Goldman even came out and said they expected it to hit 3.5% in the next six months.

More pain may come. The meager 2% yields on the individual muni side and even 4.5-5%+ (tax free) on the CEF side will not be enough to raise another possibly 5-5%. 10%+ to compensate for the decreased NAV. .

Distributions are starting to break, many more to come

We have already seen 24 cuts in CEF muni distributions in April. There are 6 in March, 1 in February and 3 in January. It may seem like a lot, but there are 119 CEF of municipal bonds on the market. And many of them, like the MFS funds,micro adjustmentAlmost monthly payments.

In all of last year there were only 30 CEF muni cuts and only 21 that were more than 2%.

It looks like we're going to do it on a monthly basis, at least for the next few months, as backers size their distributions appropriately for the new cost of leverage and the current environment.

The question is whether fund backers are adjusting to what they need now or whether they are predicting what they think leverage costs will be 3, 6 or 9 months from now.

As I have pointed out many times, the benefits will be reduced by 15-20% on average. We could see that some funds that were already earning less than expected and/or have unfavorable leverage could do so.cut more.

check outDWS City Revenue (KTF)which has now cut three times for a total reduction of -16.7%.

Distributions are the number one reason investors buyequipped,therefore, while many investors may dismiss NAV declines as temporary, they cannot accept NAV declines and distribution cuts.

Our strategy would be to find those funds that have decent UNII and UNII trends, have strong returns, favorable redemption schedules, and have recently cut enough to support them enough that they don't have to cut again.Ideal, the market would sell those short funds, which would also give us a good entry point.

How to Think About CEFs for Municipal Bonds

Most CEF investors are retail investors and may be too focused on short-term thinking or on performance for short periods of time. Long-term investing seems to be disappearing in most of the market.

Commish JW had a great quote not long ago:

Every time you buy a bond ("muni"), it's like putting a brick in the wall. I will never look at it or the price again. People can't do that with CEFs because they look at the price every day.

And here's another one more specific about CEF muni:

If you buy municipal CEFs, automatically reinvest dividends (for those not currently dependent on income) if you can use "dollar cost averaging" or, alternatively, immediately reinvest distributions in the "better/cheapest" municipal CEF that has. Build actions. Interest on interest is a powerful force over time."

Most municipal bond investors buy based on the stream of income. At the end of 2018, we saw a similar macro setup and a decline in NAVs as interest rates rose. Many distributions were also cut back then, similar to what we expect in 2022.

As I mentioned not long ago, investors should realize that decreases in municipal CEF NAVs are NOT the result of increased credit risk and higher yields.VANits capital, but higher interest and returnsOPyou capital

In other words, investors need to realize that these are LONG TERM investments that will experience a roller coaster in value. However, if we can weather the distribution cuts, we can focus and maintain strong revenue streams.

Reinvesting distribution during these times could lead to some significant improvements in revenue streams that could help offset any cutbacks that occur. Just a year ago there were virtually no funds paying more than 5% and very few funds paying more than 4.5%. Today there are 63 funds that pay more than 5.0% and even 5 funds that pay more than 6.0% and three that pay more than 7.0% (some of which are subject to taxes and ROC).

The decreases in the NAV are due to rising interest rates and not due to defaults or an increased credit risk environment that could lead to subsequent defaults. At some point, rates will fall and these values ​​will go back up. In the meantime, investors who can bear to see their investments fall for a few more months before recovering should stick with them and keep getting paid.

Too many investors focus on these investments with too short a time frame. If they were intended as a short-term investment, they would be issued with maturities of less than 20 or 30 years. But they rarely are...

What should investors do with their Muni portfolios today?

Portfolios full of municipal CEFs are probably down about 15% since the start of the year or about 3 times less than what the S&P 500 has lost. This is counterintuitive, as lower-risk and lower-risk assets beta should fall less than riskier assets.

The problem is that the cause of that fall is a variable based on credit or risk. Interest rates are rising for all the wrong reasons. Generally, rates in expansionary environments increase as growth accelerates. Today we see a slowdown in growth (significant as the Atlanta Fed's now Q1 GDP estimate is just 0.7%).

In more normal times with that kind of slowdown, rates would drop if it weren't for this current inflation problem. Eventually, supply chains will clog and demand will slow, which could drive prices down or at least significantly slow their rise.

From a portfolio perspective, we are contrarian investors, which means we would like to invest in sectors that are declining and take our profits from sectors that are in demand and well priced. Most sectors in the bond world are mean-reverting, which means that there is a fair value line that you can trade. This is a longer cycle 'trade' which means we rotate every 12-36 months, not hourly.

In September of last year, we sold and transferred a significant number of municipal CEFs to open funds such as NHMAX, OPTAX, GSMTX and MMHIX, among others. This is a countercyclical approach to valuations despite what I noted above (that munis are meant to be long-term, income-oriented investments). For me, I am not in retirement mode and I am NOT living on income.

But you'll notice I didn't look for cash. Betweenothermunicipal assets. The end result is basically that I removed the discount risk from the photo, but kept the general exposure: munis. I also reduced my leverage risk a bit, although some of those open ends do have leverage like a CEF muni.

So what should investors do with their muni-CEFs that they hold for the entire period?

Unfortunately, there is no ready answer. If you can tolerate volatility and NAV declines (and probably widening of the discount), then I'd just wait and focus on tax swaps (booking the loss and turning over to another muni CEF) to offset future capital gains .

Now is not the time to sell and switch to dry powder. You have to ask yourself how you would feel if you sold today and within the next month prices fell and municipal CEF NAVs rebounded by 5%, or 10% or more. That may be harder to swallow than another few percentage points of decline in market value due to interest rate hikes.

Is it time to buy?

As I mentioned earlier, I was very surprised at how the discount has responded to this extremely aggressive rate increase. I am very surprised that we are not back to that 99th percentile in municipal CEF refunds today. Even if we were, I don't know how aggressively I would buy today either, as I think rates continue to rise and could continue to rise for most of the rest of this year.

We may still get there as we move through the summer and investors tire (pun intended) of their municipal CEF losses and leave the room. I really think all the talk about a recession in the financial media is helping to create some demand for muni and specifically CEF muni. I also think last year's valuations - given how rich they were - also help create a sense of value or "cheap" in the municipal CEF market. After all, it's been almost four years since municipal CEFs were so cheap.

Right now the only purchases I have made are tax swaps and some distribution support. That means we are moving from some funds with lower funding ratios and UNII to funds in our Muni Core Portfolio tab that are rated Buy.

Some investors may wish to start building some new positions (net total increase in exposure) in their municipal CEF portfolios. That could be pulling back from municipal mutual funds or other lower-risk assets and substitutes for cash or cash itself. Or it could be fresh new capital from a one-time event or cash flow.

I would suggest some sort of dollar cost averaging program where you set a target allocation for municipal CEFs in your portfolio and simply buy a portion of that percentage every week, every other week or every month for a target duration (I suggest 9 months ). ).

So if you want to end up with a 10% weighting for muni CEFs, you would buy around 1.1% per month for the next nine months, doing tax loss swaps and other distribution/valuation swaps in the meantime.

Today's Top Picks for Distribution Stability

Clearly, any fund that has cut sharply and comes from a backer who tends to cut once and be done is the best place for distribution stability. As we've noted multiple times in recent months, opportunities are likely to arise as these distribution cuts continue. This is especially true if they reduce by more than -15%. In some cases, we may see the new yield close to what it was before the downgrade if investors sell the stock. That would be a great opportunity if it presents itself.

Have patience with this one.It may take up to 3 months for the discount to increase after a significant discount.

The criteria I use below are a combination of fundamental and valuation factors. We want distribution stability, strong returns, but also a good supply right now. It doesn't make sense if we really have to pay to get better performance and/or distribution stability.

(1) main term defined by MacKay Muni Opp (mmd), yield 5.72%, discount -5.6%.

The distribution has been announced for the next three months. The coverage is 100% and the fund has a large UNII deposit. The -5.6% discount is approximately 2.5 standard deviations below the five-year average. Hard to beat in this current environment.

(2) Nuveen AMT Free Muni Credit (ANE), yield 4.97%, discount -8.8%

NEA just reduced their distribution by 5% (and NVG has too). That brings coverage to 102.8% and UNII remains positive at +2c. Nuveen seems to be a bit proactive here to get the hedge back above 100%, but without making any major cuts to future leverage cost increases. That's a negative here, but future cuts should be in the same ballpark as this one, maybe a bit more.

(3) BNY Mellon Strategic Township (LEÓN), yield 5.12%, discount -8.6%

LEO cut from $0.035 to $0.03 (-14.3%) in October, which could be enough to keep it afloat for some time. The latest coverage rate is 109% and UNII is +2.2c. That doesn't make him immune to future cuts, but it will probably take time to burn through that coverage and UNII. The discount was extended year-wide again on Monday.

Sister funds DMF and DSM were also down +11% last week. Be careful with those funds to sell as they haven't acted on refunds yet.

(4) Blackrock MuniChaleco (MVF), yield 5.16%, discount -10.5%

The fund has 99.7% coverage and a small amount of UNII, but has been able to navigate the environment well. UNII has been relatively stable, so any cuts to come are likely to be small. The discount here is very large and an attractive purchase.

Alternativa: Blackrock MuniYield Quality III (SELL), yield 5.16%, discount -10.7%, has higher UNII of +5.8c but lower coverage of 97.6%. MYI and MVF are very similar, so you may want to spread your bets.

(5) County of Eaton Vance (EVN), yield 5.05%, discount -9.04%

This is a top-tier fund that has spared no effort in recent years. Coverage is 99.8% and the fund still has 6c of UNII stored. It's also a bit higher quality compared to the backgrounds from Nuveen and Mainstay. The current discount is now more than 1.5 standard deviations below the five-year average of -6.2%.

(6) Invesco PA Value Muni (VPV), profitability 5.02%, discount -13.3%

I didn't want to put a state fund on this list because I think nationals are better value here. However, this fund has just been cut by 7% and the discount is extremely wide at -13.3%, along with a tax-free return of over 5%. And if you live in Pennsylvania, you're also tax-free at the state level.

(7) PIMCO municipal income (FMP), yield 5.7%, premium +0.2%

I've had a hard time recommending a fund that trades at a premium, even if it's only a small premium, when so many funds have double-digit discounts. However, this fund has a return of 5.7%, giving you a hedge should PIMCO need to reduce this split. However, the coverage is 111.1% and the UNII is +10c. It's rare to have to cut numbers like that. The small premium is actually the cheapest this fund has traded in almost 4 years and is almost 2 standard deviations below its 5-year average valuation.

ON WATCH:

(1) BNY Mellon Municipal Bond Infrastructure (DMB), yield 5.36%, discount -9.7%

They stopped reporting call times about 18 months ago, but the last time they did, there were big calls this year and next. This is because the fund was launched in 2013 and most holdings have 9-10 years before they are callable. They haven't cut distribution in over five years. Hard to beat that kind of consistency. I just don't like that they stopped reporting it, probably because I'm cynical and they suck. Please note that performance is above average and may be reduced while still being competitive. This is NOT a reason to run out and sell.

(2) quality Nuveen Muni Inc (ELLA), yield 5.53%, discount -9.6%

I'm always suspicious when your sister cuts herself and you don't. We saw cuts on NVG, NEA, and NZF, but for some reason Nuveen didn't feel the need to apply the same blade to NAD, even though coverage is only 94.5% and UNII dropped to 4c. They may want to lower that UNII even further, closer to zero before cutting, just to be safe.

final thoughts

NAVs continue to free fall and we are only seeing distribution outages filtering through the municipal sector. As the Fed raises rates and very short-term (<1 year) yields approach the current 2-year yield, many more funds will cut their distributions.

There is a lag effect here and it will take time for all of this to happen. As the Fed raises rates over the next two months, the short end (1m-, 3m-) will move higher and the entire curve will flatten. That is what muni CEF investors care about and what will actually lead to cuts in muni distribution.

For now, I remain cautious and largely in a wait-and-see pattern if rates stabilize and the flow of money reverses. Given this morning's inflation report, we could be on the brink of that, but we'll see.