April 15 may be behind us, but it’s not too soon to start planning ahead for 2019 taxes. Municipal bonds are attractive after-tax investments for those in higher tax brackets and do a better job of diversifying stock risk than corporate bonds. Although attractive national muni bond ETFs are available, closed-end municipal bond funds are currently selling at above-average discounts to NAV and may be an especially attractive way to invest in the space. In particular, AllianceBernstein National Municipal Income Fund (AFB) is selling at an unusually large discount of 12%. In addition to its attractive distribution yield and moderate level of interest rate and credit risk, buying its assets at 88 cents on the dollar makes it an especially appealing investment for high tax bracket investors. If the NAV discount reverts back toward a more normal level, which my research indicates is likely, it will be icing on the cake.
The Primary Reason to Invest in Munis: Tax-Free Income
To determine if municipal bonds might be an attractive investment for you, the first step is to estimate your marginal tax rate. This is the rate that you will pay on the last or “marginal” dollar of income (not your overall average tax rate). The table below is provided by the Tax Foundation:
For those whose income puts them in the top three brackets, chances are that some allocation to municipal bonds will make sense. Note that the table above applies only to federal income taxes. Most states also tax bond interest income. However, most states do not tax interest on municipal bonds issued by municipalities within their own state, including bonds issued by the state itself. Investors in states with high tax rates, such as California, New Jersey, and New York, often find it most attractive to invest in municipal bonds or bond funds that focus on their state. This article will focus on national municipal bond funds. However, if you are in a high-tax state, you may find that investing in a fund focused on your state will be more attractive.
The graph below is an “apples to apples” comparison of after-tax yields between municipal, corporate, and Treasury bonds. A 35% tax is applied to Treasury and corporate bonds. A marginal tax rate (MTR) of 35% is the mid-point within the highest three federal tax brackets.
Two kinds of risk matter most for bonds: credit risk and interest rate risk. Treasury bonds have no credit risk. Defaults of municipal bonds are very rare. A Moody’s study of municipal bond defaults over the last 42 years revealed that only .8% of investment grade bonds defaulted within 10 years of issuance. Commenting on that study, Nuveen says “The 10-year average cumulative default rate for investment grade municipal bonds through 2017 totaled only 1.23%, compared to corporate bonds at 7.10%. AAA corporate bonds defaulted at a similar rate to BBB municipal debt, at 0.81% and 1.15%, respectively.”
With credit risk so low for investment grade muni bonds, the most relevant risk is interest rate risk, as measured by duration, which calibrates the sensitivity of bond prices to changes in interest rates. In the last few years, the duration of muni bonds has been less than that of comparable corporate bonds.
The primary risk in nearly all portfolios is stock market risk. That is the risk that needs to be diversified with bonds. The way to statistically measure the diversification benefit of an investment is its correlation with the stock market—the lower the better. Municipal bonds usually have a lower correlation with stocks than corporate bonds, so they do a better job of diversifying stock market risk, though not quite as low as Treasury bonds.
A Good Way to Invest in Munis: ETFs
There are two very large and liquid low-cost national municipal bond exchange-traded funds (ETFs) that are quite popular with investors: iShares National Muni Bond ETF (MUB) and Vanguard Tax-Exempt Bond ETF (VTEB). We consider them the most attractive default national muni bond funds because of their very low expense ratios (.07% and .08%, respectively) and tight bid-ask spreads. Both are passively-managed index funds based on the same benchmark index: S&P National AMT-Free Municipal Bond Index. Consequently, their characteristics and holdings are highly similar and representative of the entire municipal bond market. To represent the short end of the muni market, we use iShares iBonds Sep 2020 Term Muni Bond ETF (IBMI), which tracks a market-value-weighted index of investment-grade AMT-Free municipal bonds that mature between June and August of 2020.
As shown in the graph below, an investor with a 35% MTR will find that any combination of IBMI and VTEB or MUB will, from a yield/risk standpoint, dominate Treasury ETFs. Because of their low expense ratios and bid-ask spreads, we use Schwab Short-Term US Treasury ETF (SCHO) and Schwab Intermediate-Term US Treasury ETF (SCHR) to represent the Treasury market.
The municipal bond yield curve, unlike the Treasury yield curve, still has a very positive slope. This means that investors are rewarded for taking on incremental interest rate risk in the muni bond market.
A Better Way to Invest in Munis: Closed-End Funds
Another way to invest in municipal bonds is through a muni bond closed-end fund. Closed-end funds (CEFs) are mutual funds that have a fixed number of shares and trade during the day on exchanges like stocks. They differ from open-end mutual funds that are bought and sold in direct transactions with the fund company at the fund’s net asset value (NAV)—the value of the underlying portfolio. In this respect, they are similar to ETFs. However, because ETFs can easily increase or decrease shares outstanding, ETFs trade at prices very close to NAV. Closed-end funds often trade at prices that differ from NAV by a substantial amount—usually at a discount. These persistent discounts are a puzzling anomaly and sometimes provide very attractive investment opportunities.
At Sapient Investments, our investment universe includes not only nearly 500 ETFs, but also over 500 closed-end funds—every CEF that trades in the U.S. Our quantitative research has found that CEF NAV discounts are extremely strong indicators of value. Unusually large NAV discounts usually revert back towards their historical average, providing an important boost to return. In fact, we have found that the NAV discounts of closed-end funds is the single most powerful and persistent investment anomaly available to investors today.
In addition to trading at prices that may differ from NAV, closed-end funds also differ from open-end funds and ETFs in that closed-end funds may utilize a limited amount of leverage. Structural leverage increases the amount of assets owned by the fund. For example, a $100 investment in a closed-end fund with 40% structural leverage will have a portfolio of $140 in assets and $40 in debt. The average amount of leverage among closed-end funds utilizing structural leverage is 26%.
Because closed-end funds can borrow at much lower interest rates than individuals, owning closed-end funds is an economically attractive way for individual investors to obtain leverage. As long as the rate paid on the debt is lower than the return on the assets purchased with the debt, the fund will enhance its return with leverage. If the opposite is the case, the fund will magnify its losses. The use of debt increases the risk of a closed-end fund, but in a controlled and rational way. About two-thirds of closed end funds utilize some form of debt. At Sapient Investments, we consider a reasonable level of cheap leverage to be one of the most attractive features of closed-end funds. Nearly all financial companies utilize leverage at much higher levels. Much of Warren Buffett’s long-term alpha can be explained by Berkshire Hathaway’s use of cheap leverage at an average level of 1.6 to 1, according to one well-known study.
Perhaps because of their largely retail ownership, CEFs are mostly bought on the basis of their distribution yield. Other considerations, such as their level of interest rate risk (duration) are often poorly understood. If a higher yield can be obtained by going out further on the maturity spectrum, CEF managements know that most of their investors will approve. As shown below, the median yield for national muni CEFs is decidedly higher than for the overall muni market as represented by VTEB/MUB, but interest rate risk is also higher.
At Sapient Investments, what attracts us to municipal bond CEFs is not their higher yield/duration tradeoff. Rather, our interest in them lies with their relatively inefficient pricing. For those with the data, the know-how, and the motivation to dig deeper, inefficiency means opportunity.
For example, although CEFs usually trade at a discount to their NAVs, the level of the discount varies widely over time and across CEFs. Our research shows that there are strong mean-reverting tendencies in NAV discounts. That is, they tend to revert back towards their average levels if they get too away. Keeping track of the NAV discounts provides an opportunity to add considerably to prospective return. In fact, our research indicates that the NAV discount factor is the single most powerful ETF or CEF selection factor in our arsenal.
Our Top Choice Among National Muni Bond Closed-End Funds: AFB
Currently, our favorite national municipal bond fund is AllianceBernstein National Municipal Income Fund (AFB). Here are the reasons we like it:
- Unusually large (12.4%) NAV discount compared to other CEFs and AFB’s own history
- Conservative distributions covered by portfolio income
- Below-average duration (interest rate risk) compared to other national CEFs
- Attractive distribution yield of 4.16%
- Leverage of 41% (takes advantage of cheap short-term borrowing rates)
- Moderate expense ratio of 2.02% (includes 1.04% in interest expense)
AFB’s NAV Discount. On May 31, 2019, AFB’s NAV was $15.06, so its price of $13.20 was at a 12.4% discount to NAV ([15.06-13.20]/15.06). That’s $15.06 in value for a price of $13.20. The value of that NAV is rock solid. AFB’s portfolio is not subjective or difficult to price. It consists of publicly traded municipal bonds. Even if the NAV discount never goes away, the investor benefits from the economic value, and cash flow generating capability, of the full $15.06. If AFB were trading at its NAV of $15.06 on May 31, 2019, the distribution rate would have been 3.65% (.0458 x 12 / 15.06) instead of 4.16%. That’s an additional .51% in yield just from buying on the cheap!
Sapient’s Proprietary CEF Return Factors
Up to this point, all of the information we have cited is generic, publicly available information. What sets us apart is what comes next. At Sapient Investments, we use sophisticated quantitative analysis to forecast the expected returns of every closed-end fund in the U.S. We look for a combination of value and momentum characteristics.
Value Factor: NAV Discount. We can’t go into detail about all of our proprietary factors. However, we will do a quick deep dive on the one we consider most important: NAV Discount. Buying a CEF at a price below the NAV of its portfolio is clearly a value strategy. Our research indicates that the NAV discount factor is the single most powerful CEF selection factor in our arsenal. The graph below illustrates one of our research tests for this factor. We begin our test at the end of 2012, when NAV data first became available in FactSet. At the end of each month, we form a “Top 5” portfolio of the five CEFs with the largest NAV discounts. Each has a 20% weight. We calculate the residual return of this portfolio during the month and then re-select and rebalance the “Top 5” portfolio at the end of the next month, and so on. Similarly, at the end of each month we also form a “Bottom 5” portfolio of the five CEFs with the smallest, or most negative, NAV discounts, re-selecting and rebalancing monthly.
Other Factors. The graph above depicts the test for only one factor: the simple NAV discount. In addition, at Sapient Investments we use several other factors to forecast the residual returns of CEFs. Our research indicates that almost as powerful as the simple NAV discount are variations that compare the current NAV discount to the historical average discount for that CEF, buying only those with an unusually large discount relative to that CEF’s own history. Also, changes in distribution amounts are quite powerful in the short run. And mean reversion in long-run (3, 5, and 10-year) total return is a very effective value indicator. Finally, 12-month NAV return momentum is very helpful as well.
Overall Model. Below we present test results for our overall return forecasting model within the national closed-end muni fund universe. This includes the effects of all of the factors we use to forecast residual return as well the effects of systematic return factors, including the distribution yield. The blue line is the cumulative log of total return (not residual return) of an equal-weighted portfolio of the five national muni CEFs with the highest total return forecasts, rebalanced monthly. Since 2012, the average log of total return has been 9.7% per year on average. The orange line is the same thing but investing in the five with the lowest (or most negative) total return forecasts. That return has been -2.0%. The green line is a long-short implementation of the strategy. Its return has been 11.7% per year. The results have been both strong and consistent, particularly on the long side.
AFB’s Total Return Forecast
As of May 31, 2019, AFB had the 5th highest alpha forecast among the 81 national muni CEFs in our universe, and the highest alpha on a risk-adjusted basis. AFB has a powerful combination of extremely attractive value, as reflected by its unusually large NAV discount of 12.4%, and return momentum that is well above average. Primarily driven by these factors, our alpha model indicates that we can expect an additional .39% return over the next month. If sustained, this would annualize into a 12-month risk-adjusted return forecast of 4.64% (shown in dark brown below). Combined with AFB’s distribution yield of 4.16% (in orange below), this translates into an expected tax-free total return of 8.80% (4.16% yield + 4.64% price change). This is among the highest total return forecasts among all 81 national muni CEFs, and is particularly attractive given AFB’s relatively low level of interest rate risk (duration) compared to most other national muni bond CEFs.