Joseph G. Mowrer III, BridgeTower Media Newswires
In our opinion municipal bond closed-end funds (CEFs) are well positioned for price appreciation in the future. We started a rebound in price on the first trading days of 2019 (source: Bloomberg). However, it is our opinion that these shares are still significantly undervalued. Our research indicates three reasons that we believe substantiates this belief, although we cannot promise the future.
First, municipal bond prices have decreased throughout most of 2018 (source: Bloomberg) While the overall bond market has experienced a rebound in the 4th quarter of 2018; the municipal bond market has not kept pace. We believe that seasonal tax-loss selling is the reason for this. Municipal bond holders have been selling their bonds to realize a capital loss in 2018 to offset gains they may have elsewhere in their portfolios. The result of this selling pressure has been municipal bond prices have lagged similar maturity Treasury bonds, and are poised for a sharp rebound.
To illustrate, since the beginning of November, bond yields have decreased incredibly fast. The 30-year Treasury bond yield dropped by over .5% from Nov. 2 to year-end. (or about +10% increase in bond price!)(Source: Bloomberg) Municipal bond prices, which ordinarily move mostly in accordance with the Treasury bond market, have experienced less than half of this price appreciation, or only about 3-4%. (Source: Bloomberg). We believe that they have a lot of catching up to do and this will happen in early 2019 now that tax-loss harvesting season is behind us.
In addition to lagging municipal bond prices, there is more to this story in our opinion. Closed-end funds that own these municipal bonds have experienced an additional 3-5% of price declines also likely due to tax-loss selling in our opinion. As a result, these funds reached discounts not seen since the 2008 – 2009 financial crisis. (source: Bloomberg — and they quickly rebounded back then, making that perhaps the single greatest municipal CEF buying opportunity we have evidenced). Our research leads us to believe that shares should rebound as selling pressure is gone, and investors replace the shares they sold last year. In fact, discounts on these funds closed by roughly 1.5% in the first day of 2019 (source: Bloomberg) — a fairly big move, but perhaps just the beginning steps toward normalization.
Third, these funds earn high levels of tax-free income of around 5%. (source: Bloomberg) The market has absorbed the latest Federal Funds rate hike, and has determined that further increases are now much less likely than previously thought. It is our view that the market is pricing in a high probability that short-term rates will not increase in 2019, and may actually decrease. According to a Dec 31 Wall Street Journal poll, there was an 88% chance that rates will either hold steady, or decrease in 2019. So for closed-end funds that borrow at short term rates for the purpose of enhancing yields, this is very good news. Dividends are unlikely to be impaired, and these funds can continue to earn in excess of 5% income.
Our experience following these cycles tells us that this opportunity will not last beyond 3 to 6 months in our opinion. It’s anyone’s guess which way interest rates will move next. So rather than trying to guess the next direction of interest rates, we believe that there is value in closed-end municipal funds presently in the market. We cannot, however, guaranty future performance.
This Market Commentary is the opinion of Karpus as of the date written and is for informational purposes. While reasonable care has been taken to ensure that the information herein is factually correct, Karpus makes no representation or guarantee as to its accuracy or completeness. The information herein is subject to analysis of the market at the time of publication and is subject to change without notice. It should not be assumed that correlations based on our analysis of historical returns will persist in the future. This information is included for informational purposes only and reflect the opinion of Karpus. It should not be assumed that any security discussed will prove to be profitable or that the investment decisions we make in the future will be profitable or will equal the performance of any security discussed herein. This information should not be considered a recommendation to purchase or sell any particular security.
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Joseph G. Mowrer III is a senior tax-sensitive 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.
