Many of us blame Meredith Whitney for the fall of the municipal bond market at the end of 2010. However, municipals began falling prior to Meredith’s 60 Minutes appearance on December 19, 2010. Meredith’s report brought national attention to the municipal bond market and created a tremendous short term trading opportunity. The purpose of this report is to caution investors holding Long Term Levered Municipal Closed End Funds (LMCEFs). I currently recommend municipal bond holdings to investors with taxable accounts. This may sound contradictory based on the title of this article, but please continue reading to understand my position.
Municipal bonds are purchased for two primary reasons, tax-free income and safety. I believe both of these reasons are true and I don’t believe they are likely to change in the near future. Many investors believe that municipals may lose their tax-exempt status or are likely to experience high defaults, but I am not among them. What concerns me today is that many investors are in need of current income and are over allocating to LMCEFs.
Closed end funds are different than normal mutual funds, because they have a fixed number of shares outstanding, trade in the secondary market and can borrow money to purchase additional securities. This leveraging effect magnifies the interest the fund receives, creating a larger yield that an unlevered fund. This leverage also exasperates price movements in the investments comprising the portfolio.
I have found that individual investors are the biggest buyers of these securities, focusing primarily on the yield. These investors tend to be very conservative and react poorly to movements in price, often buying high and selling low. Recently, demand for these securities has increased, creating total returns last year in excess of 20%. This is a combination of several factors: recovery from the 2010-11 sell off, expected income tax legislation, yield preference, record low interest rate environment, etc. I believe that we are beginning to see a price peak in this category, to be followed by a moderate correction. I expect to see a 5-10% price correction in the next few months, wiping out 1-1.5 years’ future income. This correction will not be caused by municipal defaults or a global collapse, but by a change in investor preference.
Currently, interest rates are being kept artificially low by the Federal Reserve. QE1, QE2, Operation Twist and the expected QE3 have taken long term treasury interest rates to unbelievable lows. As investors, we assess assets based on their combined risk and reward profile. The risk in long term treasuries far outweighs the risks, which is why many investors have turned to long maturity municipals. Investor behavior changes as new information is received. In 2008 and 2009, investors preferred cash in order to protect savings, shunning risky investments. Today, we consistently see money flowing out of equity funds into bond funds, a sign that investors remain risk adverse. I am concerned that investors are chasing yield and are overly pessimistic about the global economy.
Although the global economy is still recovering from the credit crisis, equities are garnering greater attention. Based on momentum, futures and option pricing, an equity rally is anticipated in the coming months. Equities are not the focus of this article, but bear mentioning based on their historic relationship to long term municipal bonds. If investors regain confidence and buy stocks, they may sell fixed income positions. A stock market rally may lead investors to demand less bonds, resulting in lower bond prices. This was most noticeable in September 2010 and early 2011 when investors regained confidence in the stock market, albeit briefly. I believe that we will see a similar pattern in the near future resulting in price decreases in long maturity municipal bonds.
As previously mentioned, I am concerned with investors chasing yield. The most concerning areas are long term bonds considered to be low risk, namely treasuries and municipals. Since treasuries are subject to manipulation by the government, I have focused my attention to municipals. The recent price appreciation in long term municipal bonds concerns me. I believe investors have overbought this category based on overly pessimistic economic views. I decided to focus on closed end funds due to their use of leverage and the yield seeking behavior typical of their investors.
Based on my research, I sold my LMCEFs this year and would reestablish positions only after a correction. In order to illustrate my thesis, I ran a screen through www.cefconnect.com on January 16, 2012. I searched for levered national municipal funds with assets over $300 million that are currently trading at par or a premium (results below). As you can see, the average fund is levered by over 38%, yields 6.49%, is trading at a 3.5% premium, has a duration of 12.74 and an average maturity of 17.95 years. Because of the leverage, long maturities and high duration a small increase in interest demanded by investors can lead to a rather large price decrease in the fund. I believe investors will favor riskier categories and will begin selling some of their municipal bonds, specifically the long maturities. A small .5% increase in interest rates can easily lead to a 6% reduction in price of a long term municipal bond. Since LMCEFs can trade above or below their net asset level (NAV) and use leverage, this can create a 10% price reduction in the underlying fund price.
I am most concerned with investors holding significant exposure to these securities (above 20%). Investors’ portfolios that contain a high concentration to LMCEFs should consider reducing their exposure. I am aware that many of these investors derive a great deal of their income from these securities, but would recommend reallocating a portion of these investments. As income is a major concern for my clients, I will follow up this article with some recommended alternatives to the securities contained herein.
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