Buy Side

Market Shrugs Off Hits to Closed-End Fund NAVs

At least a dozen prominent municipal bond closed-end funds saw sharp declines to their net asset values late last week, some by as much as 230 basis points, and many by more than 200.

This is not surprising, industry analysts say. Most of the funds are heavily leveraged and are reacting to rising rates. Furthermore, seasonal factors — such as lighter cash flows, heavier supply and lower demand, mixed in with the approaching tax season — go some ways to explain the drop-off.

What's more, recent economic data and record-breaking moves by the Dow Jones Industrial Average last week drove bond investors in equities, a trader in Florida said. As nonfarm payroll numbers arrived Friday far above expectations and the unemployment number fell, the hits to closed-end funds continued.

But the downward moves of the funds have been described as more idiosyncratic, rather than systematic, once a broader perspective is taken into account, said Sean Carney, BlackRock muni strategist.

"I don't think the move is overly surprising," he said. "By nature, these are longer-duration, levered instruments that react as such when rates rise, like we've seen recently."

Among closed-end funds, munis represent approximately one-third of the $250 billion market, said Michael Jabara, executive director, head of exchange-traded fund and closed-end fund research at Morgan Stanley Smith Barney. Running the numbers for last week, the average muni closed-end fund was down 1.0% on a market-price basis and down 1.1% on an NAV basis, Jabara said.

Looking back 13 weeks, and the average muni closed-end fund is down 0.6% on a market-price basis; the NAV is down 0.4%, he added. But since Nov. 13, when the 10-year Treasury yield stood at 1.59%, the average muni closed-end fund was down 2.5%. But on a NAV basis they've been essentially flat.

"These funds aren't all that liquid," Jabara said. "So, you can get 1%-to-2% declines regularly."

The leverage makes a difference, analysts add. NAVs fall as rates rise. And the vast majority of the hardest hit closed-end funds are levered, said Duane McAllister, co-manager of the BMO intermediate tax free fund at BMO Global Asset Management U.S.

"You've got a levered security to begin with, so it's supposed to be a bit more volatile than your traditional open-end mutual fund," he said.

If a fund is 33% leveraged, for example, its managers are borrowing one third of what's in the fund. Then the gains or losses will be magnified based on the degree of leverage, said John Mousseau, a portfolio manager at Cumberland Advisors. But funds are liable to see more downward price action because of that leverage.

Seasonal factors also play a role. An anticipated increase in supply should arrive at a bad time. The volume uptick will meet investors who've already spent much of their year-end money and face tax season in around a month.

Investors flocked to closed-end funds for their attractive yields. One could easily find a current yield of 5.5% in a leveraged national muni closed-end fund, Jabara said.

And as many funds in the space borrow money cheaply when times are flush, they create big dividend cushions. Thus, even if funds must cut their distribution during periods when they underperform, they have a cash cushion which they can tap.

On the downside, Jabara added, muni closed-end funds are trading richly by historical measures. They're also very long-duration vehicles, so they leave investors exposed when rates rise. In addition, closed-end funds should pack a fair amount of reinvest risk in this space over the next year, or so.

Weekly reporting muni bond mutual fund flows reflected the prevailing mood among investors. They recorded outflows — albeit light — after eight consecutive weeks of inflows, Lipper FMI numbers showed.

Much has been written about the great rotation from bonds to stocks. But at present, McAllister doesn't see the shift happening in any major way, beyond the movement of some marginal flows.

And even those managed programs that have started to allocate more into stocks and less into bonds in the wake of the economic data have not timed the market well, Mousseau added.

"Look at what the Dow and the S&P 500 have done, in terms of rising, since November," he said. "I'd contend that some of these allocation switches are after the horses have already left the barn."



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