On July 20, 2015 we wrote a strategic article entitled “Finding Value in the Ninth Inning of the Great Bond Rally” which made the case for an investment in closed end mutual funds (CEF’s) backed by municipal bonds. This article reviews the original investment thesis, updates the reader on the performance and attributes of the securities we recommended and concludes with new advice on the position.
In the original article, we analyzed 50 muni-backed CEF’s in order to select a manageable sub-set of securities offering the most potential. The analysis supporting the recommendation relied upon many self-imposed factors and risk constraints, many of which we will not rehash in this article and some of which we did not detail in the prior article. There are three factors, however, which are worth reviewing as we evaluate and potentially change our investment recommendation. They are as follows:
Discount to Net Asset Value (NAV) – Closed end funds frequently trade at a premium or discount to their net asset value (current market value of the securities held by the fund). One of the driving factors behind our investment decision was the fact that many muni-backed CEF’s were trading at historically large discounts to their NAVs. We believed at that time, barring severe credit dislocations in the municipal bond sector that CEF investors would benefit from the normalizing discounts.
Interest Rate Forecast – We have written numerous times that we expect the U.S. economy will continue to be plagued with weak economic growth and increasing deflationary pressures. Such an environment typically bodes well for fixed income assets, specifically those that are investment grade. This theory which would result in even lower interest rates was another factor supporting our recommendation.
Municipal Yield Spread to Treasuries – Like all bonds, municipals trade at a yield spread, or differential, to U.S. Treasury bonds. Statistically, the relationship between municipal bond yields and Treasury bond yields exhibits a strong correlation. The spread can help astute investors create more dependable risk/reward forecasts.When the original paper was written, we calculated that municipal bonds were trading at a premium versus U.S. Treasury bonds. While the risk existed that the yield spread would normalize, we thought the advantages of the discount to NAV and our overriding interest rate forecast would more than offset the potential yield spread risk.
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