In a universe of more than 260 closed-end municipal bond funds, Thomas J. Herzfeld likes one. The rest he is selling.
Since the end of March, investors have been snapping up closed-end funds and bidding up prices. Herzfeld, who is chairman of Thomas J. Herzfeld Advisors, thinks this round of buying has run its course. He expects to see closed-end funds cough up some of those gains.
A closed-end fund is a pool of assets whose ownership is broken into shares that trade on a stock exchange. The asset class differs from mutual funds because closed-end funds cannot be redeemed at the value of assets represented by the share.
For this reason, closed-end funds usually trade at a price that does not match the underlying assets. A fund that is more valuable than its assets is trading at a premium; a fund that is cheaper than its assets is trading at a discount.
Herzfeld sees the premiums and discounts in the market value of closed-end funds relative to the value of the funds’ underlying assets as working “like a rubber band that gets stretched,” continuously widening and narrowing.
He likes to examine a closed-end fund’s average discount over time, buy the fund when the discount is wider than average by more than three to five percentage points, and sell it at a narrower discount.
In the fourth quarter last year, with panicked markets hampered by illiquidity, discounts on muni closed-end funds ballooned way past their ordinary discounts.
Herzfeld bought. That paid off: his closed-end muni portfolio is up more than 20% so far both because the discounts have narrowed and because the bonds in the funds’ portfolios have been on a tear. Now he has exited almost all his muni positions and is waiting for a retreat.
The average discount for all closed-end funds now is less than 8%, according to Herzfeld’s Miami-based firm. At the end of last year, the average discount was almost 13%. In mid-October, it reached more than 26.2%.
Herzfeld looks for discounts in the $71 billion closed-end muni fund sector to expand by at least five percentage points. He expects share prices to fall relative to the assets in which they represent ownership.
“Right now it’s a clear selling moment,” said Herzfeld, who has written six books about closed-end funds. “We are looking for a correction.”
Last month he sold the Nuveen Michigan Quality Income Municipal Fund (symbol: NUM), which at $11.81 trades at a 15.4% discount to its net asset value per share of $13.96. In December, the fund traded at a discount of more than 24%.
He also sold the Nuveen Michigan Premium Income Municipal Fund (NMP) last month. That fund trades at around $11.53, which is a 15.3% discount to net asset value of $13.61 per share. To put that into perspective, the fund traded at a discount of about 27% around the end of October, and was at 22% as recently as March.
Another fund he sold is the BlackRock MuniYield Michigan Insured Fund (MIY), which trades at $11.77, a 15% discount to net asset value per share of $13.85. The discount was at more than 30% last year.
A linchpin of Herzfeld’s outlook on muni closed-end funds is contrarianism. In this troubled market, the only type of new closed-end fund underwriters have been able to launch is municipal funds.
In his 40 years in this industry, Herzfeld has noticed that banks do not sell the best ideas to investors. They sell what investors are eager to buy.
“If I see new funds coming to market in a certain category that means it’s what the investors want, and if investors want it it’s usually late in the cycle,” he said.
Another underpinning of this bearish position is the leverage many closed-end funds employ. Many sell auction-rate preferred shares to try and enhance returns.
An ARPS is a special class of stock that is essentially a loan, requiring the fund to pay an interest rate that resets regularly. The idea is the fund can invest proceeds from an ARPS sale and collect a higher rate than the fund pays on its ARPS.
Under the Investment Company Act of 1940, funds must have at least $2 of assets for every $1 in ARPS. If the market value of a fund’s assets falls, it might breach this ratio and have to buy back some ARPS to maintain adequate coverage. This can mean selling bonds that belong to shareholders in order to repay lenders.
Herzfeld is buying funds’ ARPS, anticipating that they will have to buy back their own ARPS to reduce their indebtedness.This is just what happened to a few Pacific Investment Management Co. funds late last year. According to a Stifel Nicolaus report in March, about half of all ARPS issued by closed-end funds have been redeemed.
Herzfeld is not violently bearish on the sector. He does not expect a “dramatic widening” in discounts. He just thinks it’s time to sell into the market’s strength. In his monthly report, he said he remains “prepared to buy if there is a pullback.”
Closed-end funds held $183.52 billion in assets at the end of the first quarter, according to the ICI. Almost 39% of closed-end fund assets were in munis.
The one fund Herzfeld kept in his portfolio is the Delaware Investments Arizona Municipal Income Fund (VAZ), which at $10.64 trades at a roughly 19% discount to net asset value of $13.19. Other than that, Herzfeld has about 88% of his muni portfolio in an asset far less susceptible to discounts: cash.