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A Native New Yorker Reluctantly Considers 3 Jersey Municipal CEFs

These three New Jersey municipal CEFs warrant consideration, despite the state's fiscal woes. 

Steven Pikelny, 03/02/2012

The last two CEF Weekly articles focused on municipal closed-end-fund, or CEF, investing at the state level in New York and California. While national muni funds offer greater geographic diversification than state funds, the latter group offers a greater tax incentive. This week we look at CEFs focusing on the New Jersey muni market, whose state's residents face one of the highest income tax rates in the country. Individuals and couples with more than $500,000 in taxable income, for example, are subject to a 9% state tax on top of the 35% federal income tax. Investing in New Jersey municipal bonds effectively gives about an 85% boost to take-away income.

Before we look at specific funds, investors may wonder whether investing in the New Jersey municipal market is a wise decision. The state has long been a poster child for fiscal insolvency, after all. Governor Chris Christie was interviewed by "60 Minutes" alongside Meredith Whitney in late 2010 in an episode that predicted a widespread default of municipalities and states. Whitney's interview is frequently cited as a big factor in spooking muni investors. Christie didn't exactly paint a reassuring picture. About this time last year, things were not looking good for New Jersey. The state faced a fiscal 2012 shortfall of $10.5 billion (about 36% of the general fund budget), one of the highest unfunded pension obligations in the country, and a downgrade of its general obligation debt to AA- from AA.

One year later, New Jersey has closed its deficit and, with four months left in its fiscal year, projects a small surplus for fiscal 2013. The state is now focusing on closing its massive unfunded pension obligation and has allocated an ample amount of funds (about $1.5 billion) towards its municipal aid program. These actions have decreased the credit risk for individual municipalities, whose credit ratings may not necessarily correspond to the state's rating.

New Jersey investors should note that the New Jersey municipal debt market is much smaller than it is in other states. As such, fund portfolios typically contain bonds issued in Pennsylvania, New York, and U.S. territories. While the income from U.S. territory bonds are, oddly enough, exempt from federal and state taxes, income from the other out-of-state bonds are not. On average, 9.3% of each New Jersey CEF portfolio is made up of bonds not exempt from state taxes, and 8.5% of each open-end New Jersey muni portfolio is made up of these bonds. Nevertheless, investors might find this sliver of taxable bonds worth it for the ability to construct a diversified portfolio with little work on their part.

The small size of the New Jersey municipal market also means that the bonds are more illiquid. As such, New Jersey municipal CEFs have an advantage over the equivalent open-end funds in that they have the freedom of focusing on bonds with the highest return potential without having to worry about fund inflows and outflows.

Although we highlighted five New York and California muni CEFs in our last two CEF Weekly articles, the smaller market for bonds issued in the Garden State means that there is a much smaller pool of funds to choose from (14 in sum). This week we chose to highlight our favorite three New Jersey municipal CEFs.

Invesco Van Kampen NJ Investment Grade VTJ
For the income-oriented investor, Invesco Van Kampen NJ Investment Grade offers a good risk/return trade-off. The fund currently pays the highest distribution rate on this list at 6.3% of share price and 6.6% of net asset value, or NAV. Over the past five years, the fund has slowly raised its monthly distribution to $0.095 per share from $0.067. Aside from a 2007 year-end capital gains distribution, the distribution has consisted entirely of income over that period. Its undistributed net investment income balance, or UNII, now rests at $0.4717 per share and consistently increased alongside the distribution. Total return to NAV has also been above average. Over trailing one-, three-, and five-year periods, the fund returned an annualized 26.1%, 14.9%, and 5.8%, while the average New Jersey municipal CEF returned 21.5%, 13.7%, and 5.8%.

However, investors should be prepared for higher NAV volatility as well. The fund's higher-than-average leverage ratio (total assets/net assets) of 1.62 has led to NAV standard deviations of 4.4%, 5.1%, and 7.6%, over one-, three-, and five year periods. In comparison, New Jersey municipal CEFs had average NAV standard deviations of 3.9%, 4.8%, and 7.4% over the same periods.

The fund's average-weighted credit rating of BBB is about average, and its leverage-adjusted modified duration (a measure of interest-rate sensitivity) is higher than the peer average at 12.9 years. The portfolio's highest concentrations are in pre-refunded bonds (which are backed by U.S. Treasuries) at 15.6% of assets, miscellaneous revenue bonds at 11.8% of assets, and dedicated tax bonds at 9.9% of assets.

The fund charges the second-lowest expense ratio of the New Jersey municipal CEF category, at 0.99%. Invesco's municipal investment team has 14 portfolio managers and 13 credit analysts. Mark Paris, Julius Williams, and Robert Wimmel have been with the fund since 2007, 2009, and 2001, respectively.

BlackRock MuniYield New Jersey MYJ
Investors looking for a potentially lower volatility option should consider BlackRock MuniYield New Jersey. The fund's weighted-average credit quality of BBB+ is above the peer average; its average duration of 9.3 years is below the peer average; and its leverage ratio of 1.48 is in line with peers. Tax-backed bonds account for 50% of assets, while health-care and education bonds account for 11.7% and 10.7% of assets, respectively. Moreover, 28.6% of the portfolio consists of insured bonds.

Though the current portfolio is of higher quality than in the past five years, its volatility-adjusted performance has been impressive. The fund's NAV had an annualized total return of 23.7%, 13.5%, and 6.3% over one-, three-, and five-year periods, while its NAV standard deviation was 4.1%, 4.6%, and 6.7%.

Along with this lower volatility, however, the fund has a lower-than-average distribution rate of 5.4% at share price. Over the past five years, the distribution increased by 25% to $0.0725 per share from $0.058 per share. Its UNII balance has also increased over this period and is now $0.2271 per share, which is enough to cover about three months of distribution payments. Investors subject to the Alternative Minimum Tax should note that 13.3% of its assets are subject to the tax.

BlackRock MuniHoldings New Jersey Quality MUJ
Like MYJ, BlackRock MuniHoldings New Jersey Quality has increased its portfolio quality over the past five years and has generally seen good returns with lower-than-average volatility over the period. Over trailing one-, three-, and five-year periods, the fund had total returns to NAV of 21.6%, 11.4%, and 6.5%, with NAV standard deviations of 4.0%, 4.5%, and 6.4%.

The fund's average-weighted credit rating of A is the second highest of the New Jersey municipal CEF peer group, while it's weighted duration of 9.8 years is below average, and its 1.54 leverage ratio is about average. Though the fund eliminated a mandate to invest exclusively in insured funds in 2010, the portfolio still has a 71% exposure to insured bonds. Tax-backed bonds make up 46.4% of holdings, while top revenue sectors include transportation (15.1%) and education (9.6%).

The fund currently pays a monthly distribution of $0.074 per share, which translates to a 5.5% distribution rate at share price. After two decreases in 2007 (to $0.053 per share), the distribution was increased 4 times to its current level. Similarly, the UNII balance was negative for much of 2007 but turned positive in 2009 and is now $0.2012 per share.

Both of the previously mentioned funds are managed by BlackRock's municipal-bond team, which includes 12 credit analysts and is led by Walter O'Connor and Theodore Jaeckel. O'Connor and Jaeckel comanage about $20 billion across more than 60 funds. MYJ and MUJ have adjusted-expense ratios of 1.15%, which are lower than the 1.27% average of New Jersey municipal CEFs.

New Jersey is not completely out of the fiscal-insolvency woods yet, but the government seems to be making progress. Provided that the state doesn't become ground zero for the alleged muni-apocalypse, these three CEFs have the potential to provide compelling tax-exempt income for residents.

Steven Pikelny is a closed-end fund analyst at Morningstar.
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