"You can't get killed falling off of the curb."
-- Grandma Koufax
On a risk/reward basis, closed-end municipal bond funds provide the possibility of an attractive upside return compared to limited downside risk, within the context of either a short- or intermediate-term time frame.
Below is my rationale:
- Municipal bond funds, under the pressure of credit quality problems and rising interest rates, now sell at a near-record discount to net asset values (over 10%) and at a near-record pretax equivalent yield relative to taxable bonds (high grade and junk).
- The above conditions of larger-than-historic discounts to net asset value and fear of higher interest rates provide investors and traders with a margin of safety, which, for me, is integral to forming the foundation of every investment.
- Here is an example of the asset class's serial underperformance. I have arbitrarily produced the year-to-date price performance of the Invesco Pennsylvania Value Municipal Income Trust (VPV).
- Municipal bond funds are under intense year-end tax selling pressure (which should soon evaporate), as investors seek to offset large unrealized gains in stocks and other asset classes. Gold and municipal bonds were the big losers in 2013; they are for sale (but for only another two weeks).
- Municipal bond funds are under extreme selling from redeeming investors. Last week a record $1.8 billion was disintermediated in the asset class. Nearly $50 billion was redeemed in the asset class this year (compared to the prior yearly record of only about $20 billion).
- The average after-tax return of the group of closed-end municipal bond funds I have recently purchased exceeds 7%; the pretax equivalent return is in excess of 10%. (Note: If you lived in California and purchased Cali munis with 9% returns, the return on a taxable equivalent basis is over 14%!)
- If interest rates drop (as few expect) and credit quality concerns abate (as few expect), discounts to net asset value will likely close and total 12-month returns for the funds I have purchased could be at least 15% without very much risk.
- By purchasing these funds investors are getting a superior borrowing rate (on average the funds are about 30% leveraged), getting municipal bond expertise and possessing a diversified portfolio and a liquid investment that could be sold at any time.
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