Kass Katch: Buy Closed-End Munis

"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.

The risks to the trade are quite obvious -- namely, more municipal credit quality issues might surface (jeopardizing the dividend payouts), interest rates could surge and outflows could continue.

From my perch, the timing of the trade is now, as last week's price action and huge volume transacted appeared to resemble capitulation. I expect a quick January- February recovery after tax selling abates.

Read Pimco's Bill Gross's recent commentary -- he is personally buying closed-end municipal bond funds. Every major municipal profession I know is doing the same in their personal accounts. There is not enough liquidity for Pimco or any other institution to buy but plenty for us mere mortals.

This week probably represents the perfect timing for this trade or investment (depending on your flavor), as most participants are not in during the Christmas week and most of the tax selling will soon be done.

Today's contrarian purchases are at (or right after) the most severe pressure of tax selling. (Note: In Monday's trading interest rates climbed, but every single closed-end municipal bond fund was up modestly in price. This is exactly what I have been waiting for!)

Purchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt, and not all tax-exempt bonds are exempt from all federal and state taxes. The laws governing the taxability of municipal bond income are complex. At the federal level, they are contained in the IRS Code (Sections 103, 141-150). Each state will have its own laws governing what bonds (if any) are exempt from state taxes.

The best thing to do if you are considering this investment theme is to contact your investment adviser for tax suitability.

Keep in mind that your primary residence indicates which municipal bond fund you should own. If you are a resident of a state with no income tax (Florida, Nevada, Washington, Texas, Alaska, South Dakota or Wyoming), all the interest you receive is tax exempt. Thus, you are free to pick and choose among the best and safest closed-end municipal bond funds because you have no state tax liability as well as a federal tax exemption. I am a Florida resident for tax purposes, so I shop around for the best deals, and a package (see below) provides me with portfolio diversification of risk.

Toward that end, I have bought a package of closed-end municipal bond funds (I have no favorite), including: VPV, Invesco Trust for Investment Grade Municipals ( VGM), Invesco California Value Municipal Income Trust ( VCV), Nuveen Quality Income Municipal Fund ( NQU), Nuveen Select Quality Municipal Fund ( NQS), Nuveen Premium Income Municipal Fund II ( NPM), Nuveen Premium Income Municipal Fund ( NPI), Nuveen Municipal Market Opportunity Fund ( NMO), Nuveen Municipal Advantage Fund ( NMA), Nuveen Dividend Advantage Municipal Fund ( NAD), Eaton Vance Municipal Income Term Trust ( ETX), BlackRock Municipal Target Term Trust ( BTT) and BlackRock Investment Quality Municipal Trust ( BKN).

My current intention is to treat this package of bonds as an investment, though a short-term trade (January to February) to the upside is quite likely.

I plan to keep my package of closed-end municipal bond funds for the next two to three years. I remain confident that the bonds will likely outperform (on an absolute and risk-adjusted basis) the S&P 500 over that time frame.


This column originally appeared on Real Money Pro at 8:46 a.m. EST on Dec. 17.

At the time of publication, Kass and/or his funds were long VPV, VGM, VCV, NQU, NQS, NPM, NPI, NMO, NMA, NAD, ETX, BTT and BKN, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

More from Investing

Musk's The Boring Company Just Got a Bit Less Boring

Musk's The Boring Company Just Got a Bit Less Boring

Bitcoin Today: Prices Close to Flat in Low-Volume Trading

Bitcoin Today: Prices Close to Flat in Low-Volume Trading

Tyson Foods CEO: We Aren't Done Making Deals

Tyson Foods CEO: We Aren't Done Making Deals

Warren Buffett at Age 87 Still Does One Amazing Thing That Drives Success

Warren Buffett at Age 87 Still Does One Amazing Thing That Drives Success

Amazon, Nvidia, Micron and 10 Other Stocks to Own in June

Amazon, Nvidia, Micron and 10 Other Stocks to Own in June