A good time to invest in muni closed-end funds

Byron S. Sass, BridgeTower Media Newswires

Taking advantage of a deal is something that everybody wants to do. It is why people wake up at four in the morning on Black Friday to fight crowds and stand in line for hours. It is also the reason shoppers spend the time to clip coupons. In essence, shoppers are willing to seek these bargains because for every dollar they save, they have an extra dollar to spend on something else or to use at a later date.

In the investment world, many closed-end funds offer this exact type of value proposition. Often times, closed-end funds trade at a discount. This means that investors can buy a dollar’s worth of assets for substantially less than what they are actually worth. Today, many municipal bond closed-end funds are attractive because of widening discounts. To assess whether municipal bond closed-end funds may be the value you are looking for in your portfolio, let’s first take a look at the basics of what they are.

A closed-end fund is an exchange traded security that issues a fixed number of shares to investors through an initial public offering (IPO). The proceeds raised from the IPO are then invested in line with the strategy of the fund. For most funds, the value of the closed-end fund is calculated at the end of the trading day and divided by the number of shares outstanding to determine the value of each share. This is what is known as the fund’s net asset value (NAV).

Because only a fixed number of shares are issued, shares of a closed-end fund can trade above or below the NAV due to the supply and demand of the market. If the shares trade above the NAV, a fund is trading at a premium. Due to a myriad of factors, closed-end funds can trade at varying levels of premiums or discounts.

Currently, municipal bond closed-end funds trade at a discount not seen since the financial crisis in 2008 (Bloomberg). In the past two years alone, from September 2016 to Oct. 9, 2018, the average on these funds has increased from -0.21% to -10.42% (Bloomberg). This means that these funds can be purchased for less than 90 cents on the dollar, but in some cases they can be purchased for less than 85 cents on the dollar.

However, this does not mean anyone can buy closed-end funds and expect big returns. It takes insight and experience to discern when to purchase closed-end funds. For example, at the end of December 2017, the average discount of municipal bond closed-end funds was at -5.2% (Bloomberg). This means that if an individual would have bought some municipal closed-end funds then they would be down almost 5% on discount widening alone.

Another driver of the widening in municipal bond closed-end funds is tax loss selling. Municipal bond closed-end funds are highly desirable for the tax-free income they can provide for investors. These same investors who seek this tax-free income also like to capitalize on tax losses to offset their gains in other investments. In years where there is significant discount widening or losses in municipals bonds, municipal bond closed-end funds can experience further selling pressure by individuals seeking to take tax losses by the end of the year.

When an investor is able to purchase a municipal bond closed-end fund at a discount, the returns they receive come from three sources.

The first source is the performance of the underlying. For this hypothetical example, assume an investor bought a closed-end fund that invested in the municipal bonds at a 15% discount. If the municipal bonds were up 4%, one would expect the closed-end fund to also be up 4%. However, this is not the case because the discount was not factored in — which leads to the second factor.

To continue with our example, let’s assume the discount also narrowed to 10%. If this happened, your investment return would be +9%. The first 4% came from the performance of the securities, and the other 5% is the second source of return, which is discount narrowing. If an investor had just purchased a municipal bond mutual fund they would have received a return of 4%. However, if the investor had purchased a closed-end fund instead, they would have received an extra 5% by buying the closed-end fund at a discount and waiting until the discount narrowed before selling it.

The third source comes in the form of an enhanced yield due to buying the closed-end fund at a discount. To illustrate this point, consider a mutual fund and a closed-end fund at a 15% discount that are both invested in the exact same portfolio of municipal bonds yielding 4%. The owner of the mutual fund would expect a 4% pay out in the form of interest payments. The closed-end fund at a 15% discount would actually offer a yield of 4.7% because you only have to pay $0.85 on the dollar to get the exact same set of bonds that an investor in a mutual fund gets for $1.

As with any investment, buying closed-end funds is rarely this simple. For investors to take advantage and navigate closed-end funds, it requires daily monitoring, knowledge of the funds, and staying up to date on the closed-end fund industry. While this may be difficult for individual investors to do on their own, they can utilize the service of an active investment manager who has in-depth knowledge, experience and a proven track record to invest on their behalf. Overall, in my opinion, the outlook for municipal bond closed-end funds is very bright and it appears there are plenty of opportunities on the horizon.

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Byron S. Sass, CFA is a fixed income analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534, (585) 586-4680.