Advantages of Tax-Free Municipal Bond Investing Panel from Pristine Advisers’ 4th Annual Closed-End Fund Investment Strategies Conference, October 29th 2104
The following article is an edited transcript from the in New York City earlier this fall. To view slides or listen to the entire presentation please visit www.CEFnetwork.com and look under the “Events Tab” or use the following link:
John Cole Scott, EVP Portfolio Manager at Closed-End Fund Advisors
Thomas Byron, Senior Portfolio Manager, Invesco
Robert Amodeo, Head of Municipals, Western Asset Management (part of Legg Mason)
Michael Taggart, VP, Director of Closed-End Fund Research, Nuveen Investments
Note: Some minor edits were made to this article since it was first published, as well as some of the comments attributed to Tom, Rob and Mike we incorrectly noted. They have now been fixed as of 12/19/14.
JCS: We’re going to get started here with the next panel talking about the advantages of tax-free investing in the closed-end fund structure. My name is John Cole Scott with Closed-End Fund Advisers. I’ve got some excellent panelists for you, some top minds in this sector. We’ve got Mike Taggart with Nuveen Investments. He’s also spent some time with Morningstar. Then we’ve got Robert from Western and Tom from Invesco.
This is going to be less of a presentation panel and more of a conversation panel. We’ve added a lot of time at the end for questions.
When people ask why closed-end funds, there are three main answers that we give at our firm. One is that it’s fixed capital, there’s no redemption pressures for those that trade muni bond funds. They typically don’t trade, some of them very actively. Then managers in the firms up here, they’re able to pick great bonds at great prices and not worry as investor sentiment shifts.
We also have leverage. Leverage is sometimes a dirty word but, in my opinion, with fixed capitalization, you add leverage, it’s a great combination for income investing.
Then we look at active management. With many closed-end funds, including muni funds, trading at 7-11% discounts, you’re effectively getting the active management for free. It’s a huge benefit.
With that, we’re going to go ahead and get into the panel. That’s the backdrop of the conversation. Michael, if you would start. Could you just give me the sense of your firm, how you approach muni bond investing with closed-end funds, and how you build the process and do the work for shareholders?
Mike: I just want to be absolutely clear with everybody. I’m the director of closed-end fund research and Nuveen Investments. Tom and Rob are the portfolio managers on the panel. Nuveen’s roots are in municipal bond investing. Today we offer a whole range of investment strategies; we analyze more than just municipal bond funds, but they are our home base. The way we approach it is we have a team of municipal credit analysts, 23 people strong. So because of that, they’re able to dig under the hood more than say if we didn’t have that large of a team.
We have over a hundred billion dollars in assets. We’re also the largest provider of national municipal closed-end funds both in terms of the assets and in terms of the number of funds. Somebody asked earlier, why don’t Nuveen and a couple of other sponsors trim down their line-ups? We have actually trimmed down our line-ups and we haven’t said that we’re going to stop. Just in a couple of weeks we’re taking four New Jersey municipal funds and turning them into one. Over the past two years we’ve removed, through consolidation, about 40 funds, primarily municipal bond funds, from our line-up.
JCS: Robert, can you discuss some of the work you do at Western, your team’s approach to buying munis, and your background.
Rob: Sure. Glad to be here everyone. Western Asset Management, we’re a fixed income only shop. We are global, we are not just focused municipal securities. Our clients can be divided into three general categories: mutual fund investors, high net worth investors, and institutional clients. The way we go about public finance investing municipal bonds, now taxable and tax-exempt, is we really begin with the bottom up security selection process. We have a team of credit analysts that are dedicated to public finance. They’re dedicated to particular sectors, so they’re resident experts on a particular sector. They’re more like generalist when it comes to regions, because whether it’s a healthcare bond, if it’s in California, Illinois, it doesn’t matter, the credit analyst focused on healthcare funds will look at all of them.
We believe that that strength of our credit team, our ability to understand what we own, that combined with the advanced analytics that we have, give us an advantage. Are we smarter than anyone else? We won’t make that claim. But we will work harder.
JCS: Perfect. Tom, could you talk about Invesco and the work that you do there?
Tom: I’m sensing a common theme here amongst the three of us in terms of research being important. I’ve been at Invesco for 33 years. Muni bond funds have been the core of my workload. We have about 23 billion assets under management, about 13 billion of that are closed-end funds. Like Nuveen, we paired our product line-up back from over 25 funds and now we’re down to about 10. We have 15 research analysts, 8 focused on high yields, 7 focused on investment grade. We are quantitative analysts. We have traders, and six or seven portfolio managers.
Muni bonds are our bread and butter as Nuveen would say. We’ve been doing munis for quite a long time. We’re good at it.
That said, we tend to stay in bigger, more liquid names, to provide liquidity, to minimize any of the fluctuation and market volatility in the portfolios. Like my two other co-panelists here, analysts are more into the team process. Analysts advise on the credits, they give internal ratings. We use PM to decide if we want to buy, hold, or sell.
Our analysts have 20 more years of experience than the state ratings agencies. We tend to pick up bond downgrades before they happen and before the market identifies them. That means we get out, let’s say it’s going from an A to triple B, we get out at the A price before it gets to the triple B price. That’s how our analysts add value.
JCS: Mike, maybe you can give some perspective with the work you’ve done both at Morningstar and Nuveen.
Mike: Earlier you mentioned that one of the things with closed-end funds in terms of offerings, yield for investors, was discounts and leverage. I think another interesting thing to bear in mind is the closed structure of the fund, and the fact that, in general, a lot of these municipal bonds are relatively illiquid.
I think that the closed structure is a good structure for the funds. I think if you look even at unleveraged “municipal” closed-end funds and compare them to say, the Morningstar category averages for the average mutual fund yield, it’s still higher. That’s on NAV, and that’s despite the fact that they’re not leveraged. Why is that? You can pick up that extra spread there because of the closed structure of the fund.
The way we think about leverage is we think about asset classes where leverage can enhance the income component of a fund’s return, and where you get a persistent return from leveraging it.
JCS: Rob and Tom, please discuss where your focus is when looking at your fund complexes, the types of leverage you’re using, and maybe some of the hedging strategies you’ve done in the portfolio either through leverage or in other ways at Western as well as Invesco.
Rob: Our leverage remains the auction rate securities, they’re outstanding. The cost of financing on those is extremely favorable with less than 10 basis points for most weeks. I would say the structure of the closed-end funds truly enables the portfolio manager to go out and dig deep into good credit stories that are overlooked by the marketplace.
An example is Detroit Water and Sewer. Why would you own that? Well, it was actually good credit. It happened just to get tagged in a solvency event that had nothing to do with the entity itself. If you drill down into the numbers, the fundamentals, and then you look at the statutory rules, the state laws, and you look at the laws in the federal bankruptcy code, you could own that type of credit in a closed-end fund a little bit more than you can in an open-end fund because you don’t need to match the redemption during the worst possible times.
The structure enables you to really do your job as an institutional investment manager. The leverage for us is permanent. We view the auction rate securities as permanent.
We’ll keep pace or even maybe appreciate in a rising rate environment, so it’s got to be a diversified strategy that enables us to maintain our dividend policy and make it a consistent dividend policy.
On top of that, we have in the past shorted U.S. Treasury futures, and now it’s a great environment to begin to take away that rate risk that’s embedded in the municipal security. When you think of the risk in the muni security you have treasury rate risk, treasury duration, you have muni duration, and muni spread. Within muni spread there’s lots of spreads: There’s geographic and there is credit spread e, if you want to fade your rate risk now, you could short U.S. Treasury futures a little bit.
Not only could you outpace in a rising rate environment if the ratios remain constant but if we move back historic averages, you’re likely to continue that pace in that perspective too.
Tom: Depending on where you are in your market cycle, you pick spots on the yield curve for total return. Last year when the rates backed up, we did a lot of swaps. We were actually able to sell longer bonds, come down the curve, get the same yield in a 10-year bond than say a 15-year bond or 20-year bond. That’s kind of the way we acted and managed our durations also, by picking a spot on the yield curve, picking a way you invest in credits. As I said before, we’re pretty much across the credit spectrum from AAA to non-rated. Non-rated bonds, in a rising interest rate environment, tend to perform better than your typical high quality bonds because they aren’t quite as correlated to each other. You get some downside protection there.
Mike: In terms of auction rate preferred securities, Nuveen Investments was the first of the large issuers to clean that up and replace that with other forms of leverage. We have a dedicated capital markets group that every day is looking specifically at closed-end fund leverage and working with our counterparties. We believe it is important to have diversified leverage types across different closed-end funds. Plus it is also important to have diversified counterparties behind the leverage.
JCS: We will start with Robert this time, to give Mike a little break. So as Nuveen or as Invesco or Western looks at the portfolios, really what’s that personality that comes through at each of your organizations to help to meet the total return goal of cash flow is not the only piece of it but also closed-end fund, big surprise, investors like yield?
Rob: It’s a balancing act, no doubt. It’s an active strategy where you look at your current dividend, you want to maintain that, you want to have a policy of a stable dividend. You don’t want to change your dividend on a regular basis, and also you want to have a strategy that could afford your investors some stability even during a rising rate environment.
With a closed-end fund you can hold back some income. You don’t have to distribute all of your income. You can look to the various income cushions and different funds and see how they are positioned to maintain a stable dividend policy. We subscribe to a stable dividend policy through this low rate environment. We’ve managed our funds and our distributions in a way we think is consistent with offering a competitive yield versus the market but at the same time understanding that closed-end fund investors hate dividend cuts.
Tom: Likewise at Invesco, we also try to maintain a stable dividend policy, which in these kinds of markets has been challenging to say the least. Obviously as interest rates come down, issuers can also refund their outstanding debt. That’s one of the problems built-in to any closed-end or even an open-end fund for that matter. You’ve got bonds that are subject to a call at any given time based upon market interest rates bound to be taken away from you.
So, to the extent you try to maintain the dividend as close as you can. You put a little extra cushion in there for things like that.
In terms of maximizing dividend and minimizing volatility, unlike some funds we tend to be investors, not traders. However, if we get something that doesn’t work right for whatever reason or we decided we want to change our outlook on where we want to invest in the curve, we’ll change and we’ll come down the curve.
If we’re in the middle of pack in total return, that’s where we want to be. We’re not trying to hit the home run. We do take some risks but we don’t take a lot of risk.
JCS: Thank you. The next area I’d like to focus on is maybe looking at the portfolios and how you look at both call risk in the bonds that you’re looking at. Are you looking at maturity risk? Maybe then also touch on the bond you’re buying, whether they’re generally priced under par or over par and how they impact. For this one, I’d love to start with you Tom.
Tom: In terms of buying bonds at premium or discount, unless you’re buying zeros right now, there are not a lot of the discounts out there.
In terms of call risk, we manage those as best we can. Right now with where rates have come from and where we predict them to go to, I think our portfolios are set up pretty well for a rising interest rate environment. We have a lot of seasoned credits and seasoned bonds in there with the shorter calls. In a rising interest rate environment, because it’s priced to a shorter call, every basis point movement is a smaller dollar movement in the NAV price.
In terms of buying new issues, most new issue bonds come with 8 or 10 year calls, and that’s what we tend to buy. Some people tend to buy kickers. That’s a bond that’s a 20-year bond priced to a 2015 or 2016 call. You pay substantially to the triple A scale for that but you’re buying income and you’re also buying down-size protection. We don’t tend to do a lot of that stuff but by the same token because we own a lot of those bonds from when they came to marketplace, we can’t kick them out of the portfolio. This is because reasons; first, it does give you the down-size protection, and second, there is a very high income component to the portfolio.
JCS: Go for it Rob.
Rob: Yes, I think book yield is key. I couldn’t agree more. When you look at a security that you purchased say 10 months ago at 6% or 7%, when you look at the break even in selling that bond, even if you have to carry forward loses tossed at the gains where you can reinvest all the proceeds without a task consequence, it’s going to be difficult to match the total return given the high book yields in some of these securities. You have to be sensitive to where your book is. The callability in this bond market is challenging.
I’d make the point that the marketplace is a good old fashioned fixed income spread marketplace. What I mean by that is we pay very close attention to option adjusted spread, which takes into consideration all of the callability, the variability, and the cash flows. We use pretty advanced technology for that, both technology that is vendor-supplied as well as technology that we’ve built ourselves. So paying close attention to option, justice spread, book yields, and managing for a total rate of return.
JCS: Michael can you weigh-in here?
Mike: I think, again, it goes back to that value thing because as you guys are saying, if we feel like we’re still being paid for carrying the actual call risk, we’ll continue to hold them and if not, then we’ll look for other opportunities.
JCS: This will be the last main question I’d like to get to before we open up for questions from the audience. If you could talk some more about who you think should be buying these funds going forward, and how advisors can position them, it might be helpful. Right now leverage is locked in at some of the best rates ever. If you look at a 10-year average for standard deviations for the muni market, it’s just below two standard deviation entry point. So, it’s a very favorable entry point.
Rob: Sure. Simple answer, everyone who pays taxes should own these types of portfolios. I’m not saying fill your portfolio with 100% closed-end funds, but when you look at the tax adjusted returns of municipal securities, given the rate of volatility within these returns, compare them to high yield, even equities, you’d be hard pressed to match the returns in the non-levered portfolio. The tax adjusted returns from municipal securities and municipal portfolios, in a non-levered form pays their taxable counterparts with less volatility. Tack on leverage on top of that, munis have somewhat of a muted volatility level attached to it.
Municipal securities should be the cornerstone of any investor’s portfolio that can benefit from tax-free income.
JCS: Tom, do you want to jump in?
Tom: I would echo what Robert said. Munis should be in everybody’s portfolio; whether or not they’re closed-end funds is up to the individual investor. I think that financial advisors need to make sure that the investor’s educated on leverage. It’s not a freebie. There is a little extra volatility in that particular fund for that extra yield. If something looks too good to be true it probably is.
JCS: I’m not the type that buys funds cheap & then sells them when they’re tight. Mike would you like to add anything?
Mike: Yes, I would agree. The need for income is growing. Tax rates are not going down. I think demand for municipals will continue to be there. I think the important thing is that long-term investors understand what the actual risk profiles of these funds are.
Leverage has benefits that over time, historically, tend to outweigh the volatility. Long term investments have benefitted from the leverage in the funds they’ve bought.
JCS: Good. Now is a great time to open up the floor for any questions from the audience.
Audience: Thanks. How do you guys think about being on the portfolio management side? How do you guys think about capital allocation? You’re talking about the dividend yield. Obviously you guys are trying to earn a good return on your NAV but also theoretically have a shareholder base that’s pleased, how do you deal with those two issues simultaneously?
Tom: I think it goes back to a combination of what we said before. You try to maintain a consistent dividend policy based upon what you can provide in the portfolio. What is a diversified portfolio in our opinion? You minimize your risk by trying to take advantage of too much of one sector or one credit or another.
In terms of improving the dividend, it’s been proven, I believe, that when your payout is higher, the discount should narrow. We’re constantly trying to figure out ways to narrow the discount margin. It’s kind of a two-edged sword, but at Invesco, we tend to try to minimize that risk by maintaining a well-diversified portfolio across a range of sectors, credit qualities, issuers.
Rob: We look at our run rates in terms of our payout ability versus the market place. A run rate takes into consideration our book yields where we bought the securities, where we’re trading today, break even rates and so forth. We look at a variety of factors to maintain stable dividend policies but we are total return managers. We’re really always looking to improve NAV while maintaining a stable dividend policy.
Mike: At Nuveen, there is largely a similar theme. We also had a look at it from a product perspective where the distributions are set by committee every month. A part of their day is taken up with various aspects of what’s going on with the funds in terms of earnings, in terms of different aspects of distributions. They’re also managed with what we call internally an income only distribution policy where that’s what they’re trying to distribute every month. We try to make it so that current shareholders are getting paid what their fund is earning for them now instead of waiting, holding off on the distribution change until it becomes a big issue.
JCS: All right, any more questions.
Audience: If we had an extended period of deflation, how would you expect that to impact your portfolios?
Tom: The knee jerk reaction would be wonderful because the curve would flatten, credit spread possibly would widen out a little bit. From a credit perspective, depending on which sectors you own, you could be helped or hurt. However, rates themselves should fall dramatically and the curve should flatten. Most of these portfolios, considering they borrow short and invest long would benefit from that perspective.
Rob: There should be other types of events happening at the same time which may not make the world look so great. Obviously inflation hurts fixed income but deflation doesn’t really help anyone.
Audience: All of you who have alluded to the likelihood that we’re about to start a period of rates rising and because we’ve been in a 30-year bond bull market I suspect many of your portfolio managers haven’t managed through the opposite of that. Many investors haven’t either, and as we saw last year, investors can take interest rates up faster than the market might expect. With those kinds of things in mind, what kinds of scenario planning, modeling are you doing for a range of outcomes that could happen as we rates start to rise?
Tom: That’s a very good question. It has been a fairly bullish market over my career. I will say in 2008 it wasn’t quite so bullish. Last summer wasn’t quite so bullish. So, we have lived through small periods of bear markets.
That said, at Invesco, we have a quantitative analysis team. We run our portfolios versus a benchmark. The benchmark is a pretty good proxy for the peer group. We try to, at the end of the day, see where our portfolio stands up versus what our perceived internal benchmark is. This, again, is a good practice for the peer group. If we’re under/overweight in any particular sector, then we may need to adjust.
If we have a corporate policy that rates are going to rise and we think it’s going to be a flat yield curve shift, we’ll look into the position that way. If not we’ll try to find ways to adjust it, etc. Keep in mind though, again, in a muni fund we’re trying total returns. It isn’t always that easy to move the ship around because you’re very cognizant of where you own specific investments are on each part of the yield curve. So you better be darn sure that you’re making the right call if you’re going to give up a bunch of book yields to readjust your holdings in the portfolio, so you’re more in-line with your stereo analysis.
Rob: Yes, I’d echo that scenario dependent optimization is key. Beyond that I think by looking at history and you look at the published indices, Barclay’s, formerly Lehman indices, are probably the more popular indices. Ironically, 1994 is one of the worst performing years even though they started back in the 70’s. Even when including the 70’s, 94’, and 99’ are the two worst years. Plus, as Tom points out, 13’ felt pretty bad too.
Inflation is unlikely to spike in the near term. We think income is key. We’re looking to own the cheapest sectors, the cheapest name and the cheapest sectors to offset the duration risk, we are fading rate risk right now. For us, at least in the near term, we don’t suspect there’s going to be a spike in inflation, so we’re okay. I just don’t see inflation picking up. It’s more of a 04’, 06’ scenario rather than 94’ but if it does turn out to be a 94’ type scenario, we’ll bring down our duration as soon as possible.
Mike: Again, I’m not a portfolio manager. We do run scenario analysis at Nuveen Asset Management for the municipal funds. They have been bringing the duration in the portfolios down, just making sure that they’re being paid properly in terms of yields like Robert said. Also, on the product level we also run different scenarios on the funds. There are two groups of people running various scenarios on each of the underlying portfolios of all of our funds just to kind of see where things might pan out, and yes, those teams talk to each other.
Audience: Since the summer we’ve had a pretty good rebound in some of the high yield municipal funds. Are we now at levels you might consider expensive or you think there’s more room to run here?
Rob: I think we’re fully valued. I think this is now a credit picker’s market place. With this run over the last 10 months, some pullback is warranted, the yield curve is flatter, and the credit spread is tighter. You just have to be active in the security selection and you have to look over a broader range of sectors, a broader range of credit qualities within those sectors. Therefore active management is key. There is less value in the market place today. Though that’s not to say there aren’t good values to be had.
Tom: I would tend to agree with that too. We’re pretty fully invested in all the funds we manage. The only reason you’d be forced to buy something that you thought was overvalued was if you’ve got money coming into the portfolios. Obviously we get coupon money coming in. So we have to make those decisions but it’s not like an open-end fund where you’re getting closed in and you’re forced to buy something that you might not want. You’re just paying more for the credit than you’re comfortable doing. In an open and closed-end fund, without that cash flow coming in, you’re forced to make those decisions and make bad decisions.
Rob: It’s a credit picker’s market right now, but within a closed-end fund structure, there are still bargains out there.
Audience: Can you just give us your thoughts on tobacco bonds and which states might look better than others?
Tom: I can go into that. Again, we have higher yield funds, we have an open side, and we have closed-end funds which is especially great. So in the high yield portfolios, they’re buying long jerseys, they’re buying long buckeyes, and they’re buying long goldens. The breakeven analysis on those, in terms of consumption decline and tobacco smoking, is a little lower than let’s say in the closed-end funds we’re buying short jerseys and short goldens. So the four halves is 23, four five eighths is 27, 5 to 29 in the jersey. We tend to buy shorter down the curve, the breakeven analysis more on the 4-5% versus 3%.
We tend to buy jerseys and goldens down the curve. Our high yield bond is buy-in, long jerseys, long buckeyes, long goldens and things like that. It will just depend on your risk tolerance. You’re talking probably 100 basis points of difference between the short and long which has come in quite a bit.
Rob: With tobacco, there’s so much uncertainty, that I see the value; it’s cheap. It’s some welcome relief there but the unique thing about tobacco is there’s a price elasticity of demand. What that means is for every 10% increase in price there’s a 4% drop in demand. If you’re younger and poorer, that’s about 12% decline in demand with 10% increase. Now there is an alternative product.
As Tom points out, some of these shorter tobacco bonds are likely to repay if demand does not drop more than 3% but almost 80% of that market place will not repay its capital if demand drops by 3%.
Tom: I should just add, in terms of our tobacco, we’re less than 2%. We probably won’t exceed that. Again, Robert’s concerns about tobacco, we’re taking that risk, we’re taking down a curve in our exposure.
Mike: Again, I’m not a portfolio manager. I can’t go down to this level of detail. Afterwards we can make sure somebody from Nuveen Asset Management follows up with you.
JCS: We’re just out of time. One thing I meant to say earlier, we looked at the rising rate stories for the muni bond world from March 2004 to September 2007. We saw that the average national muni bond fund was up. Total return was 17.1% versus the Barclay’s muni bond index which was 13.3%. So, great, thank you guys. This was awesome, hopefully for everyone.
Disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market movements or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from the October 24, 2014 issue of our CEF Universe service. Some of the opinions expressed are not those of Closed-End Fund Advisors.