We take a closer look at the three municipal CEF IPOs of 2012.
One of the largest constraining factors of launching new closed-end funds, or CEFs, is the so-called "IPO premium." For those unfamiliar with the term, CEFs conduct initial public offerings to raise their initial capital (the funds can also conduct secondary offerings or raise assets through their distribution reinvestment plans, but those come later), but the underwriting costs typically come out of the fund's net assets. This means that shares begin trading on Day 1 at a roughly 5% premium. Even for fund families with long, successful track records, this can be a difficult hurdle to overcome. After all, if investors just wait a couple of months for the premium to dissipate or simply buy a similar fund trading at a discount, why bother buying the IPO? Hence the old adage: "Closed-end fund IPOs are sold, not bought." As a result, it is unusual to see a newly minted CEF raise much in terms of assets on its IPO, and most end up being quite small.
But in the face of high investor demand, new funds are easier to launch. This was the case for the municipal CEF sector last year, which raised a total of $2.7 billion across three offerings. With the sector hovering around an average premium of 1.3% over the year, investors faced less of an opportunity cost. A 5% premium can even look like a bargain if it has sister funds trading at higher premiums.
Although the three IPOs came from different fund families, they all shared one thing in common: Each of the three funds had a windup provision set to expire within the next 20 years. In many ways, this acts as a discount-management tool. Perpetual funds may never liquidate their assets, so the amount of income generated by the portfolio is often a larger determining factor in the resulting discount or premium. Alternatively, a term provision sets a hard date on which the fund promises to return the net asset value to shareholders. Like a bond that matures on a certain date, it stands to reason that the discount or premium should dissipate as the term date approaches.
Nevertheless, not all term funds are the same. Even with a pending liquidation, portfolio managers have some options for running these types of funds. At one extreme, the manager can simply construct the entire portfolio to mature at the same time on the term date. At the other extreme, managers can take a more active approach by raising and lowering the portfolio maturity several times over the life of the fund, depending on market conditions.
MainStay Defined Term Municipal Opportunities MMD
MMD launched on June 29, 2012, raising $564 million in assets. Subadvised by MacKay Shields, this is the firm's second CEF (it also manages First Trust High Income Long/Short FSD). Although 80% of assets mature in more than 20 years, its windup provision for Dec. 31, 2024, means that the fund will have to either shorten the portfolio's maturity as the date gets closer or else face a sharp liquidation. The fund focuses on bonds at the higher end of the maturity spectrum (about 60% of assets are rated A or higher), with high concentrations in hospital, dedicated tax, general obligation, and tobacco debt. California makes up the largest state holding at 20% of assets. The fund also leverages its holdings with tender option bonds, or TOBs, giving it a leverage ratio (total assets/net assets) of about 1.40. While this is slightly lower than average for leveraged municipal CEFs, it still pushes the portfolio's duration up to 9.8 years, which opens it up to interest-rate risk.
The fund is managed by John Loffredo and Robert DiMella, who have only been with MacKay since 2009. With more than 20 years of industry experience each, the pair previously co-headed BlackRock's municipal management group. Overall, they have a solid track record. Their open-end muni fund, MainStay Tax-Free Bond MTBAX, returned an annualized 9.7%, 8.3%, and 5.7% over trailing one-, three-, and five-year periods. In comparison, similarly unleveraged long-duration national municipal funds returned an average 7.5%, 7.1%, and 5.3% over the same periods.
BlackRock Municipal Target Term BTT
Launched on Aug. 29, 2012, BTT raised a whopping $1.5 billion, which was the largest CEF IPO of the year. Considering that August was one of the highest months for muni CEF premiums, the large scale of this IPO is not so surprising. In fact, several BlackRock CEFs (for example, BlackRock MuniYield MYD, BlackRock MuniVest MVF, BlackRock MuniVest II MVT) hovered around 5% and 6% premiums for that month.
BTT has a slightly longer-term provision than MMD, expiring on Dec. 31, 2030. The strategy also differs slightly, as the fund's portfolio will be managed such that the average maturity roughly equals the time left until the windup date. BlackRock has used this format in five previous offerings, one of which is set to expire in 2020, and four of which are set to expire in 2018. Although detailed portfolio data is not yet available, other BlackRock muni CEFs are mostly positioned in midrange credit (between AA and BBB), with their highest exposures to tax-backed and health-care debt. The prospectus also indicates that, once everything is fully up and running, the fund should have a leverage ratio of about 1.67 (also provided by TOBs), making it a bit more aggressive than MMD.