Municipal CEF Yields Remain Attractive


The sharp rally we have seen across markets since the end of March is presenting a challenge to income investors. Yields across sectors are well below their highs during the March drawdown and CEF discounts have tightened making obvious bargains much more difficult to find. Add to this the fact that a number of states are beginning to reverse or slow their reopenings making the riskier parts of the income investment space vulnerable to a sharp sell-off.

One area of the income market that remains attractive is the municipal sector, particularly the cross-over rated space, that is, bonds having low investment-grade and high high-yield ratings. In this article we take a look at the tailwinds and features of this sector. Our main takeaway is that decent underlying bond yields, reduced leverage costs, higher quality profile, strong demand and attractive CEF discount valuations make this part of the income market attractive.

We also highlight the BlackRock MuniHoldings Quality Fund (MUS) which boasts a high-quality portfolio, attractive discount valuation and a strong income trajectory due to its ability to maintain a high level of leverage and low leverage costs.

Attractive Underlying Bond Yields

In the chart below we plot a number of S&P index yield-to-worst figures, specifically the major municipal indices as well as the Treasury bond index. The chart shows that higher-quality indices such as the Treasury, municipal and taxable sectors have mostly retraced their yield spikes. On the other hand the high-yield muni and crossover municipal sectors are still boasting yields that are attractive historically. As a proxy for the crossover part of the municipal market we use the S&P Municipal Yield Index which is composed of 70% non-rated or high-yield bonds, 20% BBB rated bonds and 10% rated A and above. This index is more representative of the typical municipal CEF portfolio than the other S&P indices.

Source: S&P, Systematic Income

To get a better historical picture we plot the yields above as boxplots which shows exactly where the current yields are relative to their own history. The chart shows that the current yield-to-worst of the crossover municipal sector is quite attractive in relative and absolute terms.

Source: S&P, Systematic Income

This lag in yields for the lower-rated part of the municipal market makes sense on some level, of course. Unrated and revenue bonds tend to have higher default rates and municipal sales tax receipts are significantly lower than they were just a few months ago. That said, these bonds typically fund essential services that the municipalities are unlikely to be able to do without. Furthermore, the bonds typically feature strong security provisions as they do not rely on the full faith and credit of the issuer. Finally, active management by CEFs is much more likely to be able to spot problematic securities than passive investment vehicles such as ETFs.

Attractive CEF Discount Valuation

Another attractive feature of the municipal CEF sector is its discount valuation. The sector’s discount remains relatively wide versus other sectors as well as versus its own history. Its current discount of 6.8% is at just the 15th percentile over the last 5 years, meaning it has only been wider 15% of the time.

The sector’s 5-year z-score of -0.87 compares favorably to the average sector z-score of -0.5 and particularly against the taxable sector at 1.1.

Source: Systematic Income

Reduced Leverage Costs

Municipal CEFs tend to raise leverage using two main instruments: tender option bonds and variable-rate preferreds. Both of these instruments use the SIFMA index as their base rate. If we look at the evolution of this index we can see that it has fallen back to levels that we saw in 2016. This makes sense since the Fed’s policy rate is back around the zero bound. What this means is that, in aggregate, the municipal CEF leverage costs are as low as they have been since the financial crisis. This allows municipal CEFs to maximize the amount of yield that they are able to add through leverage.

Source: Systematic Income

One of the key criteria that we look at when thinking about allocating to CEFs or open-end funds is how much the CEF is able to add to the yield of the underlying portfolio. When underlying yields are low, fund fees and leverage costs are high, CEFs can struggle to add additional yield in excess of the portfolio yield. From an income perspective, it makes much less sense to own a CEF in this scenario since investors would be taking on additional volatility without being compensated for it with an increased yield.

In order to check how the municipal CEF sector looks in this respect we calculate the excess yield that an average municipal CEF can provide by taking into account the underlying portfolio yield, average municipal CEF leverage, an average leverage cost based on SIFMA and standard spreads, average CEF fees and an average muni CEF discount. What we find is that this metric looks quite attractive currently relative to history. This is mostly due to higher underlying yields, relatively wide CEF discounts and low leverage costs. By this calculation, the average muni CEF is adding on the order of 1% to its underlying portfolio yield. Of course, exact figures vary based on the characteristics and features of individual funds, but in aggregate this is quite a strong factor in favor of the CEF allocation in the sector.

Source: Systematic Income

Higher Quality Profile

The municipal CEF sector is roughly 80% investment-grade judging by the available credit rating disclosures. This means that the sector has tended to suffer smaller drawdowns relative to other CEF sectors. This greater resilience allows investors to use the sector not only as a source of income but as a potential source of dry powder to be able to reallocate capital to other higher-octane funds. Earlier this year the sector saw a 29% average NAV drawdown (annual top-to-bottom total return) and a 40% price drawdown, significantly outperforming the average CEF sector.

Source: Systematic Income

Attractive Demand vs. Supply Picture

After several weeks of outflows demand for municipal bonds has again started to pick up. New issues continue to be absorbed at a strong clip. Low yields on strong investment grade paper is pushing investors into cross-over and high-yield bonds, supporting that part of the market. Nuveen expects net demand for investment-grade bonds to outstrip new issuance by $52bn. It is also worth remembering that unlike the corporate credit market, the municipal bond market has not grown much in the last decade while its investor base has increased. This dynamic should continue to support the sector in the medium term.

And An Idea In The Sector

In this section we highlight an attractive municipal CEF.

The BlackRock MuniHoldings Quality Fund is primarily focused on investment-grade funds with just a 7% holding in unrated and high-yield bonds. The fund closed Monday at a 10.29% discount and a 4.97% current yield. The fund is due to merge into the MuniHoldings Fund (MHD) along with four other funds by the first quarter of 2021. MUS has the widest discount of the 5 funds which could provide a small tailwind as the merged fund allocations will be done on a net asset value basis.

The discount valuation of MUS is very attractive in relative and absolute terms. The fund used to trade at a discount much more in line with the rest of the sector and has since traded on the wider side despite having a current yield that is 0.4% higher than the sector average.

Source: Systematic Income

The fund has recently raised its distribution by 13% which was not a surprise given the fund’s increasing earnings profile and strong coverage.

Source: Systematic Income

The main reason for the improving EPS is the fact that the fund’s leverage costs have been cut nearly in half. The fund sources leverage using both tender option bonds and variable-rate preferreds both of which have seen a drop in their costs of about 1%. Unlike many other municipal funds, most notably PIMCO municipal CEFs, MUS has not had to deleverage and maintains the same amount of borrowings as it did prior to the drawdown which helps it to maintain a strong level of income.


The municipal sector remains attractive in the current market environment. Decent underlying yields, a relatively strong quality profile alongside attractive discount valuations suggest it has a role to pay in income portfolios as both a source of yield and a potential store of dry powder.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MUS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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