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. 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.
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 above compares yields for the overall municipal (“muni”) bond market (using the Bloomberg Barclays Municipal Bond Index) to Treasury and Corporate indexes with a similar level of interest rate risk and (in the case of corporates) credit risk. (Over half of the muni index is rated AA, with most of the remaining bonds one notch above or below that level.) The after-tax yield is presented assuming a marginal tax rate (MTR) of 35%, the mid-point within the highest three brackets. At that MTR, as of April 30, 2019, the after-tax yield on the AA corporate bond index was 1.98% (3.04% before-tax yield x .65%). The yield on the muni bond index was 2.30%, or .32% higher.
The level of interest rate risk, measured by duration, has moved around quite a bit for the municipal bond index. Fortunately, at present the interest rate risk for the muni market is lower than average and also lower than the 5-10Y AA Corporate Index. As of April 30, 2019, the muni market index had a weighted average duration of 5.6. This indicates that if interest rates were to move up by 1%, the index would be expected to lose 5.6% of its value. By comparison, the duration of the 5-10Y AA Corporate Index was 6.3. So, at a MTR of 35%, municipal bonds offer a higher after-tax yield with a similar level of credit risk and a lower level of interest rate risk.
A (Very) Secondary Reason to Invest in Munis: Diversification
The primary risk in nearly all portfolios is stock market risk. That is the risk that needs to be diversified. The way to statistically measure the diversification benefit of an investment is its correlation with the stock market—the lower the better. Municipal bonds 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). Their expense ratios are .07% and .08% respectively, and their respective average bid-ask spreads are .01% and .02%. 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. (It used to be that the expense ratio for MUB was noticeably higher at .25%, but on June 4, 2018 iShares cut the expense ratio to .07%.)
There is also a large and liquid short-term municipal bond ETF: SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF (SHM). Its expense ratio is .20% and its average bid-ask spread is .02%. It has a lower level of interest rate risk, as measured by duration, but its yield is also quite a bit lower than the two broad municipal bond ETFs.
The demand for short-term municipals bonds is so high that it has driven down the yield on that end of the yield curve. This makes intuitive sense because most broad muni funds, especially those that specialize in a particular state, have a relatively high level of interest rate risk (duration). Many investors are concerned about rising interest rates, which could negatively affect longer-term bond funds. So, they may combine a longer-term muni fund with SHM (or something similar) to drive down their overall duration. However, given the very large give-up in yield, it appears that muni investors may be better off looking for other investments to lower their overall interest rate risk.
A Better Way to Invest in Munis: Closed-End Funds
Another possible 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.
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. The average amount of leverage among closed-end funds utilizing structural leverage is 26%. 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.
Because institutions such as 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. It is more common for bond funds to use debt and less common for equity funds.
One attractive municipal bond closed-end fund is AllianceBernstein National Municipal Income Fund (AFB). It has a management fee of .86% (it is actively managed, as are all closed-end funds) and an average bid-ask spread of .12%. On April 30, 2019, the fund’s NAV was $14.75, and its closing price was $12.98, or a 12.0% discount to NAV. This is one reason that the fund’s yield is noticeably higher than those of the competing ETFs at a similar duration.
Another reason for the high yield (called the “distribution rate”) is the fact that AFB utilizes 41% leverage, nearly all of it in variable rate preferred shares. AFB reports interest expense of 1.04% as a result of leverage, which adds to its overall expense ratio. Adding in “other expenses” of .12% sums to an overall expense ratio of 2.02% for AFB. Its distribution rate was 4.24% on April 30, 2019. At a marginal tax rate of 35%, that equates to a taxable yield of 6.52%.
However, at Sapient Investments, we are expecting an even higher return than that, primarily because of the 12% discount to NAV. That was the second-highest NAV discount among the 82 national closed-end muni funds in our database. Our research indicates that this unusually large NAV discount is likely to shrink in the months ahead, providing a boost to AFB’s return.
The graph above illustrates one of our research tests. The blue line is the cumulative log of residual return (net of our proprietary four-factor risk model) of an equal-weighted portfolio of the five national muni CEFs with the largest NAV discounts. (Log returns mean that the slope of the cumulative line has the same meaning all along the left-right axis.) The portfolio is rebalanced monthly. Since 2012, the average log of residual return (net of risk effects such as equity market and interest rate betas) has been 3.4% per year on average. Note that it is not cumulative total return that is being measured but the log of cumulative residual return. The distinction is vital. Much of the return for muni bond CEFs is systematic return, especially return derived from a CEFs sensitivity to interest rates. Residual return is the return that is left unexplained by a CEF’s systematic risk factor sensitivities, and as such is a measure of “alpha.”
The orange line is the same thing but investing in the five with the smallest (or most negative) NAV discount. That return has been -6.4%. The green line is a long-short implementation of the strategy. Its return has been 9.8% per year. The results have been both strong and consistent.
Results can be improved further by comparing 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. Our model indicates that we can expect an additional 4.4% return from AFB because of its unusually large discount to NAV both in absolute terms and compared to its own history. AFB’s NAV discount on April 30, 2019 was 12.0%. Its average discount since 2012 (when our NAV database started) was 7.5%. The average discount for all national muni closed-end funds on April 30, 2019 was 5.7%. Since 2012 the average discount for this group has been about 4.8%. So, there are a lot of possibilities for mean-reversion here. AVB could revert towards its own historical mean NAV discount. It could also revert towards the overall average NAV discount of all national muni CEFs. And the entire group could revert towards its historical average NAV discount. Or (most likely) some combination of all three.
- Municipal bonds are attractive after-tax investments for those in higher tax brackets
- They do a better job of diversifying stock risk than corporate bonds
- Two low-cost, highly liquid national muni bond ETFs are MUB and VTEB
- Closed-end municipal bond funds may be even more attractive:
- They usually sell at a discount to net asset value (NAV)
- They usually utilize a limited amount of inexpensive leverage
- Many state-focused funds are available
- Sometimes the NAV discounts are unusually large (e.g., AFB)