CEF Weekly Review: Why Muni CEFs Have Underperformed This Year

Welcome to another installment of our CEF Market Weekly Review, where we discuss closed-end fund (“CEF”) market activity from both the bottom-up – highlighting individual fund news and events – as well as the top-down – providing an overview of the broader market. We also try to provide some historical context as well as the relevant themes that look to be driving markets or that investors ought to be mindful of.

This update covers the period through the second week of September. Be sure to check out our other weekly updates covering the business development company (“BDC”) as well as the preferreds/baby bond markets for perspectives across the broader income space.

Market Action

All but 2 CEF sectors were down this week as higher Treasury yields and lower stock prices took their toll on returns. After trending lower through 2022, CEFs have been range-bound so far this year.

Discounts widened this week, with equity CEF discounts underperforming. Discounts remain not far off their wides over the last 3 years.

Market Themes

As the following chart shows, Muni CEFs have underperformed year to date. The reason is four-fold.

One, risk-free rates have risen – the 10Y Treasury yield is up almost 0.5% this year. Municipal bonds have one of the highest duration profiles across the income space.

Second, Munis feature modest yields relative to other credit assets owing to their higher-quality profile. The sweet spot for Muni CEFs is around A/AA ratings, whereas the sweet spot for corporate credit CEFs is closer to B/BB, with some exceptions. A lower level of yield means less carry to accumulate through the year.

Third, credit spreads have tightened year-to-date – about 1% if going by the HY bond market. Credit spreads tend to tighten proportionately – higher-quality / tight spread assets will see a small amount of spread change, while lower-quality/widespread assets will see a large absolute spread change. Less spread tightening for Munis translates into lower price gains, all else equal.

Fourth, Muni discounts have underperformed – widening year-to-date, whereas most CEF sectors enjoyed discount tightening. This could be because of continued distribution cuts – Munis have been hit hard by this given their fixed-income asset / floating-rate liability balance sheet profile.

What does this mean for allocation? In our view, it means that corporate credit is less appealing here given expensive valuations while higher-quality assets look pretty good, among them Munis. As usual, this is not an all-or-nothing thing, but at the margin or for new allocations, Munis look relatively compelling.

Market Commentary

September brought more CEF distribution changes. Invesco trimmed distributions on most of their CEFs with most affected being Muni funds.

Eaton Vance slightly trimmed EVV and EVG distributions once again. The two funds have a barbell allocation with a significant holding of very high-quality assets as well as lower-rated loans and bonds. However, they have a very different distribution profile, with EVG making frequent small changes and EVV making few but large changes. Eaton Vance also announced tender offers for two of their loan funds – EFT and EVF. The funds have a policy where if they trade at a discount wider than 10% for the first 8 months of the year, they will hold tender offers for up to 10% of shares at 98% of NAV. The tender offers will commence at the end of September. Not super compelling to chase at today’s valuations, but current holders should obviously keep an eye to see if tendering makes sense closer to the decision point. The bank debt CEF FINS raised the dividend by 15%. FINS along with DMO were highlighted earlier as funds whose distributions should hold up, and now both funds have raised distributions. We reallocated the FINS position a few months ago primarily to JBBB to, in part, reduce the overall Bank’s position in the Portfolios, which worked out well as JBBB is up 4% while FINS is flat.

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