EIM, EVM: 8.4% to 10.8% tax equivalent yield on A-rated government bonds
Why would you buy 3% yielding treasuries or municipal bonds when there is 8% inflation? For the answer to this and to avoid redundancy, see my last post.
After reading this, if you are on board with the the idea that now – contrary to consensus – might actually be a good time to stock up on bonds, so you might want to consider closed-end funds ((CEFs)). I received many questions about them in my last article, so here is an article about them.
For over a decade, CEFs have been my preferred way to buy bonds. Here are 3 reasons why:
1. You can buy below net asset value (NAV)
Mutual funds are open-end funds. When you buy them, the fund manager buys more of the underlying holdings and new shares for the mutual fund are created. ETFs are also mostly open-ended.
With either, you pay market prices for their holdings. Yes, ETFs may differ slightly from their underlying net asset value at any time, but due to the algorithmic method of managing ETFs, any premium/discount is miniscule. Think a few basis points, not a few percent.
With CEFs, you might be paying a few percent below NAV. Maybe even a double-digit discount. What makes this possible is that they are closed. This means that new shares are not created or withdrawn. Instead, the price is solely determined by existing holders selling and the level of demand to buy them.
When bonds are in vogue, the discount to NAV narrows and some funds even trade at a premium. When everyone hates bonds (like right now), you’ll see the discounts widen.
2. They optimize returns with leverage
To be clear, I am against the use of margin on a personal level. However, when you buy a stock or fund that uses leverage, the risk is compartmentalized and defined. Yes, you can lose some or all of your capital in the investment, but your loss will not extend beyond that. For this reason, I’m very comfortable with leveraged funds from a risk management perspective, but they’re not for everyone.
The vast majority of invested CEFs use a leverage effect of around 37 to 44%. Even if you wanted to replicate the same thing yourself and borrow money to buy bonds, these money managers’ rates will likely be lower than the margin rate offered by your broker.
The counterbalance would be that these funds charge exorbitant management fees, which is absolutely true. Most of these CEFs originated in the 90s and 2000s, before the days of ETFs and the race to the bottom in fees.
Yet, even taking management fees into account, they can be quite attractive when you consider the leverage aspect combined with the ability to buy them below NAV.
3. Much simpler than a bond ladder
Although significantly larger than the stock market, the bond market is illiquid and opaque. Unless you are a professional using MarketAxess (MKTX) or TradeWeb (TW), good luck with price discovery. Also, have fun with this tax accounting nightmare of dozens or hundreds of individual bond transactions. Luckily, I haven’t had to do that since 2013.
In short, unlike a buy and hold stock portfolio, paying a management fee for a bond portfolio makes sense.
What about the risk of municipal bankruptcies?
Do you remember all that fear after the great financial crisis, that municipalities would go bankrupt left and right?
It didn’t really play out. Far from it, in fact.
In the end, there were 8 bankruptcies in total. That’s out of 9,492 municipal governments, 16,519 township governments, and 3,033 county governments.
Could the next major financial crisis be worse? Of course and in fact, I think it will. However, it is a numbers game. Chances are that even in a 2008 scenario (or worse), only a tiny fraction will be restructured.
Muni CEFs don’t usually provide a breakdown by cities/towns/counties, but they do all provide a breakdown by state. If you want to be specific, you can get the full list of holdings from the manager. If there are certain states/cities you feel less comfortable with, just pick CEFs that hold little or none at all.
Why buy Munis rather than Treasury bonds?
Both are superior to corporate bonds because, after all, they can just keep raising taxes on us to pay their bills (the bondholders). But what makes munis vastly superior to corporations is their tax-exempt status. Most are exempt from federal income tax, and if issued by your home state, they may also be exempt from state income tax.
Compare that to treasuries, which can only be exempt from state income tax. You still have to pay federal tax on the interest earned.
Disclaimer: I am not a tax expert. Consult one to verify and confirm the imposition of your specific scenario on all bond investments.
What I bought lately
In total, there are about 115 equipped CEFs. Their market capitalizations range from as low as $19 million to $3.6 billion. The larger the fund, the greater the liquidity.
For a national municipal fund – that is, a fund that is not state-specific – I generally aim for those with a market capitalization of at least $400 million. State-specific funds have an inherently smaller audience, and therefore for those, $200 million or more suffices in my book.
Nuveen, Blackrock, Eaton Vance, PIMCO, Neuberger and Invesco take the lion’s share. Only a few are from BNY Mellon, Putnam, Alliance Bernstein and a few others.
What are the best? Well, generally I’m issuer agnostic. What matters most to me is the discount to the net asset value at that time, the characteristics of the portfolio and the management fees. For over a decade now, coincidentally, every purchase I’ve made has been from Eaton Vance, Nuveen and Blackrock.
1. Eaton Vance Municipal Bond Fund (NYSE:EIM)
This is the one I have owned regularly in a catch weight for about ten years. Over the past few weeks, I’ve increased my weighting by a few hundred percent. Here’s what I like about it:
- When adjusted for leverage, the effective duration is only 7.4 years. Most others are 10-11.
- With a net asset value of $900 million, the fund is large enough to provide liquidity.
- Credit quality is A+ versus A for the category average.
- 5% yield at current share price. This is a tax equivalent distribution rate of approximately 8.5%.
- 6% off NAV, which is good for the history of this fund, but not great. A few weeks ago it was 10%.
I’m not a fan of the relatively high exposure to Illinois right now, currently at 13.8%. Historically, it has been lower.
Prior to the bond YTD plunge, according to Morningstar, an investment of $10,000 over 10 years would have produced a total return of around $18,000. An 80% return might not look impressive against the S&P, but on a risk-adjusted basis it’s been a relatively safe way to keep pace with inflation and unlike taxable corporate bonds, it’s really kept pace. pace since you may not owe federal income. tax on distributions along the way.
2. Eaton Vance California Municipal Bond Fund (NYSE: EVM)
Coincidentally, this is another Eaton Vance fund. I never owned this one until a few weeks ago. If it was a bigger fund I would still buy, but now I own about 1/2% of the fund. Why? Because its recent rebate on NAV was a mouth-watering 12% (and a little more a few weeks ago).
- Similar to EIM, it has a below-average leverage-adjusted duration of just 7.5 years.
- The fund size of $230 million is on the small side, but not bad for a state-specific fund. There is a decent daily trading volume.
- AA- credit quality which to my knowledge is better than any other CEF in California.
- The return of 5% is relatively high for EIM. Given the shorter duration and higher credit quality, this fund typically only yields 4.25-4.5%.
- If you are a CA resident, the tax-equivalent distribution rate at market price is almost 11%.
Even if I wasn’t among the 40 million California residents, chances are I would have bought some, given the NAV discount and portfolio characteristics. I get that California looks like a train wreck to most countries, but the fact is we have immense taxing power given that our state is the 5and largest economy in the world, ahead of India and behind Germany.
Only California and New York have a large number of CEFs, each with 13 funds. As for the other specific states, your options are limited:
Arizona: Nuveen AZ Quality Muni Inc (NAZ)
Georgia: Nuveen GA Quality Muni Inc (NKG)
Massachusetts: Nuveen MA Quality Muni Inc (NMT)
Michigan: BlackRock MuniYield MI Quality (MIY)
Minnesota: Nuveen MN Quality Muni Inc (NMS)
Missouri: Nuveen MO Quality Muni Inc (NAME)
New Jersey: BlackRock MuniHoldings NJ Qty (MUJ), Nuveen NJ Quality Muni Inc (NXJ)
Ohio: Nuveen OH Quality Muni Inc (NUO)
Pennsylvania: BlackRock MuniYield PA Quality (MPA), Invesco PA Value (VPV), Nuveen PA Quality Muni Inc (NQP)
Virginia: BlackRock VA Municipal Bond (BHV), Nuveen VA Quality Muni Inc (NPV)
These state-specific options continue to dwindle over the years. For example, until recently there were 2 Michigan funds (I owned both) and 1 of them was merged into a national fund.
An important caveat
One thing to keep in mind with all bond CEFs is that they should not be considered cash equivalents. Due to bond market volatility, exacerbated by the fact that CEFs trade outside NAV, you can lose a lot of money if you sell them at the wrong time. Therefore, when I buy them, I do so on the assumption that I may not be able to sell them for years at favorable or acceptable market prices.