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Comeback Kids: Municipal Funds Made a Strong Showing This Year

Despite a bounceback in the muni market, some closed-end funds remain undervalued.

Cara Esser, 07/11/2014

Not generally known as an exciting asset class, municipal funds are what investors typically turn to for tax-advantaged income. But the municipal market made headlines last year with Detroit’s bankruptcy and Puerto Rico’s perilous financial situation. Those events, combined with the bond market’s so-called "taper tantrum," caused many investors to flee municipal open-end funds in droves. The open-end category experienced 10 consecutive months of outflows between March 2013 and December 2013. Although pension deficits in cities and states across the country and the potential for rising bond yields remain a concern for investors, tax-advantaged income lured some back to the asset class in 2014. What’s more, a supply shortage pushed spreads narrower and helped many municipal funds recover from last year’s abysmal returns. Open-end municipal-bond funds showed positive net flows for the first half of 2014. 

After a beat down in 2013, longer-dated municipal bonds have also performed well so far this year. The Bank of America Merrill Lynch Municipal 22+ Year Index gained 10.4% for the year to date through June 30, 2014, and the Bank of America Merrill Lynch Municipal 15+ Year Index gained 9.5%, compared with the Bank of America Merrill Lynch 1-5 Year Index return of just 1%. Midquality muni bonds also fared better in the first half of the year: The Bank of America Merrill Lynch BBB Index posted an 11% gain compared with a 4.5% gain for the AAA Index. 

Puerto Rico remained a hot topic among investors and portfolio managers this year, with many taking a hard-line stance. Those choosing to invest in the struggling island benefited so far this year. Despite renewed concerns, the S&P 500 Municipal Bond Puerto Rico Index gained nearly 6% for the year to date, but the index is down nearly 14% over the past year.

Municipal CEFs
After a rough 2013, investors in municipal CEFs have done well so far this year. In 2013, nearly all municipal CEFs ended the year in the red on both a net asset value and share price basis. This year, every municipal CEF posted a positive return on a net asset value basis for the first six months of 2014 and only one had a loss in share price over the period. 

Of the best-performing funds, credit quality and geographic exposures varied, but many of the top-performing funds were also the most leveraged. PIMCO CA Municipal Income II PCK, for example, had a leverage ratio of 45%, the highest of the state muni CEFs, and was the group’s top performer. That fund held no Puerto Rico bonds, and its exposure to BBB rated bonds was middle-of-the-pack. The fund did give a significant underweighting to AAA rated bonds compared with peers. 

Below are the best- and worst-performing national and state-specific municipal CEFs on a net asset value basis for the six months ended June 30.


  

In addition to credit risk, investors do need to be aware of the interest-rate risk inherent in municipal CEF portfolios. In order to meet high distribution payments, many municipal CEFs hold long-dated securities. In a rising-rate environment, the prices of long-dated securities will fall more than the prices of short-dated securities. On top of long-duration portfolios, most municipal CEFs use leverage, which amplifies the effects of rising rates on underlying portfolio values.

In addition, because most muni CEF investors are retail investors, negative headlines about the municipal market as a whole (or even a small part of the market) can cause panic among shareholders. In the past, this has led to share prices falling much faster than underlying net asset values in times of market stress. On the other hand, astute investors can use these opportunities to purchase shares of a fund that distributes tax-advantaged income at a deeply discounted price.

 

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

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