The First Trust Municipal Closed-End Fund Total Return Price Index (MNCEFT) closed above 1600 (1604.99 to be precise) on 5/15/14 for the first time since 5/24/13 when it closed at 1608.11. National municipal closed-end funds (CEFs) as measured by this index are now up 13.71% YTD and up 17.64% since 12/5/13, according to Bloomberg. As recently as 12/5/13 this index was at 1364.22. It closed above 1400 on 12/18/13, above 1500 on 2/10/14 and above 1600 on 5/15/14.
In the title above you might have noticed I used the word "silent" to describe this huge rally in municipal CEFs. I specifically used that word because owing to the 30%+ rally in the S&P 500 in 2013 coupled with the Dow Jones Industrial Average and S&P 500 recently hitting all-time highs, it has been easy for this municipal CEF rally to get lost in the shuffle. However, I suspect it would surprise a lot of investors to know that over the past six months through 5/15/14, national municipal CEFs, as measured by MNCEFT, have actually significantly outperformed the S&P 500 (15.20% for MNCEFT vs. 5.13% for the S&P 500 including distributions according to Bloomberg). Behind the rally in municipal CEFs has been a very conducive environment for municipal bonds and municipal CEFs including: very low leverage cost as a result of the federal funds rate being 0-0.25%, very compelling tax-free yields averaging north of 6% for leveraged municipal CEFs, demand for high quality tax-free investments and a lower than usual supply of municipal bonds, improving finances for many municipalities, declining interest rates and low inflation.
It was challenging last year when municipal CEFs were weak and I was making the case to investors to continue having some exposure to municipal CEFs as they were properly diversified across different categories of the CEF marketplace. But the significant rally the past six months is a good reminder of the importance of balance in a CEF portfolio, the importance of not selling into a panic (again with the caveat that as long as an investor is properly diversified) and the importance of taking advantage of these opportunities when they arise, as they did the second half of 2013.
What is my current view of municipal CEFs?
In my view, the primary risk for investors in municipal CEFs remains duration risk (duration is a measure of interest rate sensitivity). 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. Given the meaningful capital appreciation municipal CEFs have produced the past six months, I expect more of the potential total return going forward to come from the distributions municipal CEFs provide. 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 of 6.17% for national leveraged funds (as of 5/14/14 according to Morningstar), current wide discounts to NAV averaging 5.73% (as of 5/14/14 according to Morningstar) compared to discounts of only 1.43% a year ago and 2.26% three years ago and the likelihood most municipal CEFs will be 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 a fund's investment objective, and to manage a 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 a 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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