2013 was a remarkable year for domestic equities. Not only was the Standard & Poor's 500 Index up 32.37% according to Bloomberg, but it achieved these results with very little downside volatility. Indeed, August was the only negative month for the S&P 500 in 2013. With such robust returns for equities coupled with a rise in long-term interest rates last year, it is to be expected that investors could lose sight of the importance of building balanced, diversified closed-end fund (CEF) portfolios and instead be mostly focused on equities and equity CEFs. The speed and degree with which investors sold both individual municipal bonds as well as municipal CEFs during the spring and summer of 2013 illustrates this point.
However, just because municipal bonds and municipal CEFs were clearly out of favor with investors for most of 2013, it did not mean there was not value in the underlying asset class and in municipal CEFs. This was precisely why I continued to advocate CEF investors maintain some exposure to municipal CEFs as the distribution rates, distribution stability (for the majority of municipal CEFs), valuations, low leverage cost and high credit characteristics were still compelling enough to warrant they be part of a diversified, balanced portfolio of CEFs.
While I suspect some readers of this blog and CEF commentary page may have doubted the wisdom behind this thesis, the recent performance of municipal CEFs illustrates the importance of maintaining balance in a CEF portfolio even when one of the categories you own might be out of favor. This is particularly relevant in light of the choppy start to the year for the S&P 500 which is up 0.50% year-to-date (YTD) as of 3/28/14 according to Bloomberg. National municipal CEFs, as measured by the First Trust Municipal Closed-End Fund Total Return Price Index (MNCEFT), are up 8.61% YTD through 3/28/14 and up 12.37% since 12/5/13. Even with the very strong total returns since early December, I believe valuations for municipal CEFs remain attractive as the average discount to NAV was 6.08% as of 3/28/14 according to Morningstar. The average was 0.91% one year ago and 0.97% three years ago according to Morningstar. Furthermore, with the Federal Reserve likely to keep the federal funds rate at 0-0.25% through all of 2014, leverage cost for levered municipal CEFs should remain low and help most municipal CEFs to maintain their very attractive distributions. The average national, leveraged municipal CEF had a distribution rate of 6.39% as of 3/28/14 according to Morningstar. A 6.39% distribution rate is a taxable equivalent distribution rate of 9.83% for someone in the 35% tax bracket.
In my view, the primary risk for investors in municipal CEFs remains duration risk. This is why I continue to advocate that CEF investors build portfolios that blend municipal CEFs with shorter duration senior loan CEFs as well as limited duration multi-sector CEFs and domestic equity CEFs as a way to mitigate some of the duration risk inherent in municipal CEFs. The potential for higher short term interest rates (and therefore higher leverage cost) sometime in mid-2015 is something owners of leveraged municipal CEFs should be watching closely. However, for now, while municipal CEFs clearly have duration risk, I believe with average tax-free distribution rates north of 6%, current wide discounts to NAV and the likelihood most municipal CEFs are able to maintain their distributions this year and into 2015 as the Federal Reserve keeps the fed funds rate at a rock bottom 0-0.25%, investors are being compensated for the duration risk they are assuming.
The performance of the First Trust Municipal Closed-End Fund Index is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. The First Trust Municipal Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the U.S. municipal closed-end fund universe. An index cannot be purchased directly by investors.
Closed-end funds are subject to various risks, including management's ability to meet the fund's investment objective, and to manage the fund's portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors' perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund's net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.
All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.
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