Value in Muni Closed End Funds

Closed End Funds (CEF) An Example

The recent spike in rates has provided investors with a unique opportunity to invest at levels that have not been seen in a long time. Nowhere has this become more clear than in the  market for Closed End Funds (CEF’s).  Nuveen Arizona Premium Income Muni Fund (NAZ)  has had a negative return of about  –19.0% during the last year as shown in the chart below.  Part of this poor performance is due to the rise in rates we have seen since the end of April.

 

 

However,  more than half of the poor performance is due to a change in investors’ eagerness to get out of bond funds.  The NAV of the fund is currently $13.44, but the fund is trading at a discount to NAV of –11.46% for a price of $11.90 per share.  This is the biggest discount to NAV for this fund since Lehman Bros. filed for bankruptcy on 9/15/2008. The chart below shows the discount or premium to NAV over the last year.

 During the last year the share price of NAZ topped out on 1/29/2013 at $16.65 per share.  Today the shares are priced at $11.99 per share for a decline of -24.38%.  The chart below shows the move in share price for NAZ during the last year.  The price of NAZ recently took out the Meredith Whitney low of  $11.81 set on 1/18/2011, when investors sold shares after Whitney’s call for numerous high profile muni defaults.  

Opportunity For Income Investors

We believe this drop in share price has created a good entry point for income oriented investors.  The chart below shows the shares at current market price have an indicated yield of about 6.41%.  We believe this monthly dividend is relatively secure.  The fund has Undistributed Investment Income (UNII) of $0.1653 per share.  This is because the fund only pays out, on average, about 93.44% of earnings.  The remaining balance is booked as UNII.  The fund currently earns about $0.0598 per share monthly and pays out $0.064 per share.  There is enough UNII to maintain the current dividend for at least 3 more years.  At 6.41%, the Taxable Equivalent Yield (TEY)  for an Arizona investor in the maximum tax bracket is 11.47%. 

 

 

If you account for the 3.8% surtax for Obamacare for couples who are married and have a modified adjusted gross income of at least $250,000, the TEY is 12.3%.

 
Conclusion

The recent rise in rates combined with selling pressure from retail accounts has created an opportunity for income oriented investors to purchase CEF’s at very attractive TEY’s.

 

 

 

Rising Rates?

Focus on Fed Policy

Recently all eyes have been on Fed policy regarding the possible tapering of bond purchases.  This preoccupation with Fed policy has led investors to liquidate bond mutual funds and ETF’s in record amounts.  This has led to a rapid rise in interest rates to the highest levels of the last two years.  Mortgage rates have soared to 4.5% during the last six weeks.  The chart below shows the rise in 30 year mortgage rates since the Fed announced it might start tapering bond purchases.  We feel investors are currently focused on the wrong thing, and the rise in rates has created a buying opportunity in bonds.

 

 

 What Drives Interest Rates

The two primary drivers of interest rates are the general level of economic growth, and inflationary expectations.  Fed policy is largely driven by these conditions and is very much “data dependent”.  The economy only grew at a 1.8% rate during the 1st Quarter of this year.  This is significantly below the long term economic growth trend.  The Fed has had a history of being overly optimistic about future growth  in the economy.  Forecasts of higher growth rates for the rest of the year strike us as being overly optimistic, considering the recent move higher in interest rates.  We expect higher rates to slow down the housing market and the economy in general during the rest of the year.  It is important to remember that stronger economic conditions for the rest of the year is not a known event.  We feel a continued period of weak growth is more likely.  Higher tax rates, higher mortgage rates, a slowdown in government expenditures, and negative demographics are all headwinds for the economy.  The debt limit ceiling will need to be raised by early fall to keep the government running.  There has been no talk of progress made in Congress regarding the two parties working together to address the budgetary issues facing the country.  Instead, both parties are becoming even more polarized.  It is hard to imagine this changing soon.  The potential for negative noise coming out of Washington concerning budget battles and the debt ceiling  may also be a drag on the economy.

 

The chart below shows the continued decline in inflationary expectations.  This trend is not indicative of rising rates.  In fact, it seems to be providing a green light for the bond market.  Many investors believe the expansion in the Fed’s balance sheet has to be inflationary at some point.  However, the data does not support this argument at this time.

 

 

The Fed’s QE Experiment

The Fed began Quantitative Easing (QE) during the financial crisis in 2008.  Quantitative Easing occurs when the Fed expands it’s balance sheet by purchasing assets such as U.S. Treasuries and Mortgage Backed Securities.  QE is supposed to be a monetary tool which is used when the Fed Funds rate is at or near zero and unemployment is high and the Fed believes more monetary easing is necessary.  QE is a tool to lower long term interest rates to stimulate economic growth. 

 

 

The chart above shows the last two rounds of QE have not been as effective in lowering interest rates as QE1 and QE2.  The diminishing returns of QE3 and QE4 cast a shadow of doubt concerning the effectiveness of continued QE.   Quantitative Easing has been tried in Japan with little success as the Japanese have been engaged in a 20 year battle against deflation. 

 

Stuck In A Liquidity Trap

The velocity of money, as shown in the chart below, has continued its downward trend.  This is a sign we are in a classic liquidity trap, and monetary tools are relatively ineffective in stimulating the economy. 

 

 

This has occurred because there is too much debt in our system, and demographic trends are very negative for the economy.  The Fed’s monetary tools are designed to encourage borrowing to stimulate economic activity.  This does not work well in a highly indebted economy. The large number of baby boomers and longer life expectancies have created a large group of older people in the U.S.  An aging population does not have enough consumers in the accumulation phase of life.  They are not borrowers and spenders.  Instead, there are more consumers who are spending less on things, and more on healthcare.  This is  very negative for economic growth because it dampens the effectiveness of monetary policy.

 

How High Should Rates Be Without Government Manipulation?

The question fixed income investors should be asking is “how high should rates be without the government trying to manipulate the market?”  We believe the current level of rates offers value to investors.  Inflation is running at about 1%.  The Fed has made every effort to get it higher without success.  Japan has been in a similar situation.  The 10 year JGB still yields less than 1% in Japan.  Our 10 year UST yields about 2.55%.  The German bund yields 1.58%, the rate in the UK is 2.34%, and is only 2.2% in France.  Corporate and Muni yields are higher still.  Long Munis for good BBB rated bonds yield over 5%.  This equates to taxable equivalent yields of 8-10%.  These are very attractive rates for retail investors. 

 

Conclusion

Investors should pay attention to the weak trend of economic growth and low inflationary expectations.  The recent selling of bond funds has created a good opportunity for investors to add to their fixed income positions at prices which have not been available for the last 2 years.