Closed-End Municipal Bond Funds Face Steep Discounts
Closed-end municipal bond funds are experiencing wide discounts to their asset value. Some funds still offer attractive yields despite market conditions. Tax advantages and potential for high returns make these funds a lucrative opportunity for inves...
Troy D. Hanson
September 30, 2023
Closed-end municipal bond funds have been heavily impacted by the recent selloff in fixed-income markets, resulting in the widest discounts to their asset value in the past 18 years. This trend is worrisome considering that over the past year, the average muni closed-end fund discount has hovered around 10%, while the long-term average stands at approximately 5%.
Attractive Yields Despite Market Turbulence
Despite the challenging market conditions, certain muni closed-end funds are still offering attractive yields. For instance, the Nuveen AMT-Free Quality Municipal Income Fund currently yields 4.3%, while the Nuveen AMT-Free Municipal Credit Income Fund, which holds a significant portion of bonds with lower credit ratings or none at all, offers a yield of 5%. On average, muni closed-end funds yield close to 5%.
Tax Advantages and Potential for High Returns
Considering the tax advantages of municipal bonds, a 5% rate on munis can provide an equivalent yield of around 7.7% on taxable bonds for individuals in the 35% federal tax bracket. This yield expectation becomes even more appealing when factoring in state taxes, which can push the taxable-equivalent yield beyond 8%. These figures closely align with the average yield on junk bonds.
Muni Closed-End Funds: A Lucrative Opportunity
According to Eric Boughton, a portfolio manager at Matisse Capital, the recent increase in long-term rates has triggered panic among investors, leading them to abandon long-duration assets. However, Boughton believes this situation presents a significant opportunity for investors in muni closed-end funds.
Matisse Capital, through its Matisse Discounted Bond CEF Strategy (MDFIX), has increased its investment in muni funds to a 50% weighting, twice its normal allocation. The fund currently holds major positions in muni closed-end funds such as the Abrdn National Municipal Income Fund (VFL) and Nuveen Municipal Credit Income Fund (NZF). Notably, four out of its five largest muni holdings have discounts of 16% or more.
A Promising Contender: BlackRock Municipal 2030 Target Term Trust (BTT)
Investors seeking opportunities in the muni closed-end fund space should pay close attention to the BlackRock Municipal 2030 Target Term Trust (BTT), currently trading at around $19.30 with a 13% discount to net asset value. While its dividend yield may seem modest at 3.5%, the fund aims to deliver a return of $25 per share to investors by 2030. If this target is achieved, or even comes close to it, investors could potentially earn an estimated 7% annualized return.
It is worth noting that most muni closed-end funds do not have a predetermined termination date, making BTT particularly appealing.
Closed-end municipal bond funds have endured a triple blow, causing their decline in recent times.
Municipal Bond Funds Face Challenges
Municipal bond funds are currently facing challenges due to recent selloffs in fixed-income markets. These funds typically hold longer-term municipal bonds with maturities of 15 to 20 years, which have been particularly affected. Compounding the issue, these funds are often leveraged, meaning they borrow around 50 cents for every dollar of equity, amplifying losses in a declining market.
Another factor affecting these funds is the rise in short-term rates, which is reducing the rate spreads they earn on their leveraged assets. The muni short-term rate benchmark, known as Sifma, has jumped from near zero to about 4% since early 2022. Since municipal bonds are currently yielding in the 4% to 5% range, the benefits gained from borrowing are largely offset.
The impact of these factors has led to a widespread decrease in dividends among muni closed-end funds. For example, the Nuveen AMT-Free Quality Municipal fund's dividend has dropped by approximately 40% since early 2022, now standing at an annual rate of 42 cents per share.
One issue for investors in muni closed-end funds is the substantial fees that can be associated with them, usually around one percentage point. In order to offer competitive dividends compared to other muni investments like individual bonds and exchange-traded funds, these funds often need to trade at discounts to their net asset value.
To illustrate, a Los Angeles airport 5% bond due in 2022 currently yields about 5%, providing a strong yield for an AA-rated bond and creating competition for muni closed-end funds.
Although it has proven challenging for activists to convert closed-end funds into open-end funds - a move that would eliminate discounts and benefit investors - the significant discounts present in muni closed-end funds still offer attractive yields and better liquidity compared to individual munis traded over-the-counter. Given their leverage, these funds are positioned for potential appreciation if long-term rates begin to decrease.