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A November to Forget for Muni CEF Investors

This year's strong rally in municipal CEFs has sharply corrected as inflation expectations soar. 

Cara Esser, 12/15/2016

Alaina Bompiedi contributed to this article.

Investors in closed-end municipal-bond funds have a lot of grievances to air around the aluminum pole this Festivus. A number of closed-end fund Morningstar Categories posted double-digit losses for the month of November. While some of the declines can be attributed to the surprise of the election outcome, investors were also anticipating that the Federal Reserve would raise interest rates at its December meeting (which it did by 25 basis points). According to the CME's FedWatch, as of Dec. 12, the market assigned a 97% probability to a 25- to 50-basis-point hike. Generally speaking, CEFs investing in bonds have fairly long durations, making them more susceptible to price declines when rates rise. This is especially the case for CEFs investing in municipal bonds.

A Closer Look at Muni CEFs
Municipal-bond CEFs took a beating in November, and post-election losses have been remarkable. Exhibit 1 shows the returns of several muni CEF categories and  open-end categories for the month ended Nov. 30 and for the year to date.

Long-term, intermediate-term, and high-yield muni-bond CEF categories all turned negative for the year after November's sell-off. Heading into the month, the average net asset value of long-term and high-yield munis were up more than 5%.

The future of muni CEFs remains murky largely owing to the uncertainty around the incoming administration's plans for infrastructure spending and tax cuts, as well as rising expectations of inflation. For starters, while campaigning, Donald Trump promised increased infrastructure spending, which would be a positive for muni-bond investors, but it's unclear exactly what his plans are and it's also unclear that the Republican-led congress would agree to increased spending.

Arguably the biggest headwind for muni investors is the value of the tax exemption for muni income under a new tax regime. Again, details are sparse on potential future tax rates, but Republicans generally favor lowering tax rates on investment income earned. That rate is now (typically) equal to an investor's income tax rate; some pundits estimate it could be a low as half that under the new regime. Lower taxes on investment income could make munis less attractive from an aftertax investment standpoint. Generally speaking, munis provide lower pretax returns than taxable fixed-income funds because the aftertax returns tend to be higher, especially for high earners. It's unlikely that lower tax rates will mean the demise of the muni market, but it could certainly make the asset class less popular with investors, which would affect the share prices of muni CEFs.

As for inflation, the five-year, five-year forward inflation expectation rate--which measures inflation expectations--has risen sharply since the election. While it was already on the rise, it jumped to 2.06% by Nov. 11 from 1.89% on election day (Nov. 8). It continued to climb and reached 2.11% at the end of November. Inflation expectations are important because inflation eats into the return of any investment, but investments with a fixed payout are hurt the most. Rising inflation means lower real (after-inflation) returns and may add to the downward pressure on share price.

CEF Discount Trends
Despite volatility on the days bookending the election, November discounts for CEFs ended more or less where they began at the beginning of the month. Muni discounts, in particular, ended merely 4 basis points above where they started on Nov. 1. A similar rebounding trend could be seen on the three-year scale for taxable fixed-income and equity CEFs. The average November discounts for these two asset classes weren't far from their first-quarter 2014 levels. Still, November was rockier than October for taxable and municipal CEFs. Their average November discounts were 130 and 217 basis points lower than their October averages, respectively. Exhibit 2 shows the average discounts for the three major CEF asset classes during the trailing three-year period. 

We use a z-statistic to measure whether a fund is "cheap" or "expensive." As background, the z-statistic measures how many standard deviations a fund's discount/premium is from its three-year average discount/premium. For instance, a fund with a z-statistic of negative 2 would be 2 standard deviations below its three-year average discount/premium. Funds with the lowest z-statistics are classified as relatively inexpensive, while those with the highest z-statistics are relatively expensive. We consider funds with a z-statistic of negative 2 or lower to be "statistically undervalued" and those with a z-statistic of 2 or higher to be "statistically overvalued." Typically, we prefer to use the three-year z-statistic, which shows the funds that are most heavily discounted relative to their prices during the past three years.

This month, leading the pack is EV Municipal Income EVN, which takes first place for the second month in a row. In November, this fund--which usually trades at a premium--reached its lowest discount since 2007. But such tax-preferred CEFs can be oddballs. On the whole, November saw municipal fixed-income CEFs trading at a slight premium over their three-year average discounts (despite the pessimistic widening we saw this past fall). It's helpful to remember that the z-statistic is a relative measure and can vary dramatically between time periods. For muni CEFs, while their one-year average z-statistic was a discounted negative 0.60 (owing to the rally in muni CEF prices from January to August and subsequent drop-off in October and November), their three-year average z-statistic was a slightly premium 0.36 at the end of November. Exhibit 3 shows the 10 most undervalued CEFs, ranked by their three-year z-statistics.

Best- and Worst-Performing CEF Categories
During November, equity CEF categories--especially those that are viewed as likely to benefit from the incoming administration's policies--tended to do well, while most fixed-income categories performed poorly. Financials was the top-performing category on both a price and NAV basis as investors expect congress to repeal or roll back many of the regulations put in place after the 2008 market crash.

The worst-performing category last month was equity precious metals, which includes a single fund, ASA Gold and Precious Metals ASA, followed by Latin America stock. Five of the 10 worst-performing categories last month were munis, largely for the reasons discussed earlier. The table below shows the best- and worst-performing CEF categories for November.

Cara Esser is a closed-end fund analyst at Morningstar.

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