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Year in Review: Municipal CEFs

We take a look at 2012's municipal CEF performance, distribution cuts, mergers, and more.

Steven Pikelny, 01/18/2013

2012 was a good year for municipal closed-end fund investors. Low short-term interest rates led to cheap leverage financing, while falling long-term municipal rates and lessening concerns over municipal credit quality led to capital appreciation.

As a result, every single municipal CEF, many of which used leverage, had positive net asset value returns for the year. Things also went well from a share price return perspective, with only one fund logging a negative return (AllianceBernstein NY Municipal Income AYN lost a paltry 0.5%). Looking past the amplified capital appreciation, the shape of the yield curve also partially influenced ubiquitous distribution cuts throughout the sector.

Income-oriented investors should note the importance of understanding these trends for the sake of future distributions. The last two weeks have been devoted to year-end reviews of taxable CEF sectors. With this in mind, let's take a closer look at the performance and major developments of the muni CEF market of 2012.

Performance



One main trend sticks out from the performance table above: 2012 paid off for riskier funds. The top 10 absolute performers all had below-average credit ratings, while eight of them had above-average leverage ratios. Similarly, eight of the 10 worst performers had either average or above-average credit ratings, while four had below-average leverage. What's more, the worst performers list is largely populated by funds that focus on intermediate- and short-term securities. Looking at the Sharpe ratios of each list (which adjusts performance for volatility, not other risk factors such as interest-rate sensitivity and credit quality), the best performers were still above-average. However, it's worth noting that four of the funds (Eaton Vance Municipal Income EVN, PIMCO Municipal Income PMF, PIMCO Municipal Income II Common PML, and PIMCO Municipal Income III PMX) had either below-average or only slightly above-average Sharpe ratios.

The other thing that sticks out is that share price returns fell short of the performance of the underlying portfolios. While the average NAV increased 15.3%, the average share price only increased 12.6%. In fact, the sector started off the year at an average 2.2% premium, winding up at a 0.2% discount.

Aside from California having appeared to dominate New York, we see some of the same trends among state funds: Three of the top five state funds had below-average credit ratings and high leverage ratios, while the worst performers were all short- or intermediate-focused funds with mostly average credit ratings and leverage ratios.



Distribution Cuts
Although the shape of the yield curve led to capital appreciation amongst muni CEFs, it also indirectly led to lower distributions. With bond yields at record lows, many municipalities exercised call options on their issuances. As a result, many CEFs faced reinvestment risk throughout the year and ultimately took on lower levels of investment income. What's more, many fund families continued to refinance toward more expensive forms of leverage (more on that below), further squeezing net investment income.

In all, 22 funds raised their distributions and 117 cut their distributions over the course of the year. 17 of these increases came from BlackRock, though the firm also cut distributions on 20 funds. Because the magnitude of the cuts (8.2% on average) was larger than the increases (2.2% on average), the average net change was a 2.3% cut across the entire muni complex. Nuveen, which was the earliest fund family to begin leverage refinancing, and which manages its funds with high degrees of call exposure, was hit with the double-whammy: Its 64 cuts led to an average 7.6% decrease in Nuveen muni distributions. From a percentage standpoint, Eaton Vance had it the worst: With 12 cuts, EV funds are paying 9.7% less in distributions, on average. Nevertheless, many Eaton Vance muni funds now have some of the lowest call exposures of the sector and now have relatively stable, albeit lower, distributions. PIMCO stood out with no distribution cuts (although four of its nine funds are currently underearning their distributions). Because the firm has yet to refinance its leverage, it enjoyed slightly higher levels of net investment income.

Corporate Actions
The muni CEF universe shrunk drastically last year through several mergers and a couple of liquidations. 2012 started with 104 national funds and 147 state funds and ended with 97 national funds and 117 state funds. In particular, Nuveen made a large effort to merge many of its state-oriented strategies down into single funds. Invesco consolidated its muni CEF lineup down to 10 from 27, but not before redeeming its funds' auction-rate preferred shares, redomesticating the funds to Delaware, eliminating outstanding insurance mandates, and nixing the legacy Van Kampen name. While these mergers give investors fewer choices for picking out value among the intricacies of the different portfolios, they still have advantages. Most obviously, they vastly simplify the firms' lineups. Looking a bit farther down the line, the increased scale recognized by the firms could potentially lead to lower fees for investors.

BlackRock continued to make progress toward potential mergers by redeeming its outstanding ARPS. The firm also liquidated two New Jersey funds. DWS and MFS refinanced their respective ARPS by conducting ARPS tender offers. In our opinion, this is more (common-) shareholder-friendly because it gives the fund a chance to redeem the preferred shares below face value. PIMCO is now the only large muni CEF fund company that has yet to fully redeem these securities.

Finally, the year saw three major municipal IPOs: Mainstay DefinedTerm Municipal Opportunities MMD ($564 million), BlackRock Municipal Target Term BTT ($1.5 billion), and Nuveen Intermediate Duration Municipal Term NID ($630 million). These funds mark a revived trend toward defined-term provisions, which can serve to help narrow discounts and commit funds to intermediate- and short-duration strategies. Next week, we'll take a closer look at each of these three funds.

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