Closed-End Muni Funds

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Spaceman Spiff's picture
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Joined: 2006-08-08

I just brought on a client who owns some muni CEFs.  He's had them for 20+ years.  Symbols are CXH, MFM, and OIA.  According to the info that ACATd in to us, he's carrying a capital loss on all of them.  20 years and he's got a capital loss?  I understand the basics of these things.  Clients like them because they see higher returns, but that's only because they are typically leveraged.  Two of the three I listed are leveraged, one of them at 45%.  They're investing in similar, if not identical, investments as open-ended MFs.       Does anyone use these?  I'm trying to decide if they're worth keeping or if I should look for alternatives for my client.   

N.D.'s picture
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Joined: 2009-07-14

Spiff - you should sell them and then buy those long individual muni bonds that Jones likes to sell so the client will have a capital loss for the next 20 years <wink>Seriously, I think LSUalum is the guy you need to ask. He uses a lot of CEFs and I believe he spends more time on the other board.

LSUAlum's picture
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Joined: 2009-10-18

The investment vehicle that I specialize in primarily are Closed End Funds. Just looking at CXH for instance. Had he bought it at inception for 12.00 per share it's currently trading at 9.24. It has a current yield of 7.08% with a Tax Equivalent yield of say 10% if he's in the 25-30% blended tax rate area. Despite the capital loss, he's made an average annual return since inception of 5.7% TAX FREE. If he's been in that same tax rate this entire time he's made an average annual Tax Equivalent yield of 7.75%. Not a terrible investment. It looks alot better now at 10% Tax Equivalent, and he hasn't had alot of price degredation from 1996 to now.CEF's are very simple in theory but require alot more finesse than some people think. The bottom line is can he take that money and make a monthly distribution of 10% tax equivalent if you sell it? The leverage is really a non-issue right now. If anything the FED is making it so that levering up your balance sheet is the absolutely right thing to do from a return perspective. BTW on this particular fund, the distributions are paid monthly and have been remarkably consistent since 2006 (the farthest back cefconnect.com goes). If he's using them for income in a nonqualified account, I really can't think of it as a bad investment at all. INLCUDING the capital loss.

Spaceman Spiff's picture
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Joined: 2006-08-08

That's exactly what I was thinking.  I think this 75 year old guy needs some 40 year paper.  I'll try a post on the other site too. 

LSUAlum's picture
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Joined: 2009-10-18

Just checked the MFS website. The return on the CXH for the last 10 years? 7.23% annually with a TaxEQ yield of 10.32% (30% bracket). Not bad for the 'lost decade' eh?

LSUAlum's picture
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Joined: 2009-10-18

Spaceman Spiff wrote:That's exactly what I was thinking.  I think this 75 year old guy needs some 40 year paper.  I'll try a post on the other site too.  I'm curious, is this agreeing that it's a good investment or being sarcastic about the investment? His income stream is better than a SPIA, can't argue with that. Especially given it's daily liquidity, rising income potential (as evidenced by the rising distributions) and portability to heirs.

N.D.'s picture
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Joined: 2009-07-14

LSU - Spiff posted that at the same time as you did so he was probably responding to me and does not know you have replied yet.

Spaceman Spiff's picture
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Joined: 2006-08-08

That post is dripping in sarcasm.  We posted at the same time and I was in the process of editing it.  You're just faster than I am.  The duration on CXH is 13.6.  Won't that fund get killed when rates rise? 

BigFirepower's picture
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Joined: 2010-07-09

Space, while he's got a 20% cap loss, if he's held it for 20 yrs, then he's only offset by 3 yrs of that income. Chances are, he thinks these are the greatest investments since sliced bread...  If he likes them, keep them until an obvious situation/opportunity arises.You sell them, and pick a decliner/loser with the proceeds, he's going to hate you. And of course, you know that...What about doing a tax loss trade on them? You give him some value added, make a few bucks, give him some write offs, while keeping an instrument he generally likes?

Spaceman Spiff's picture
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Joined: 2006-08-08

LSU - explain how leveraging a portfolio right now is a positive thing.  Just thinking about the way long term bonds are going to be affected if/when the Fed raises rates, doesn't that mean that less leverage would be more beneficial?  BFP - that's exactly what I'm considering.  I've poked around on cefconnect.com enough to know that there are some better options out there for him in that same space.  If I can increase his yield, lower his duration, and capture a tax loss, I think it's a win for everyone except the IRS. 

LSUAlum's picture
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Joined: 2009-10-18

Spaceman Spiff wrote:That post is dripping in sarcasm.  We posted at the same time and I was in the process of editing it.  You're just faster than I am.  The duration on CXH is 13.6.  Won't that fund get killed when rates rise?  Well that's the greatness of CEF's. They don't price at NAV. The value of the fund is a function of market sentiment rather than actual changes in the underlying bonds. For instance, it's currently trading at roughly a 4.5% discount to NAV. So any interest rate increases that change NAV may be offset by the market sentiment toward the investment. If tax rates were to increase, potentially the market would have a huge appetite for MUNI's and could drive up the price of the CEF well above any changes in the NAV of the underlying securities. CEF's are more volatile that corresponding MUNI Open End funds. That being said, for an investor seeking cash flow it's a superior yield. So you have to look at what CEF's are good at and what you are trying to accomplish. A UIT or Individual Bond ladder has a defined income that is consistent but has price fluctuations and is more illiquid (bid/ask spreads are higher) than a muni MF is. A MF has income that is less stable but is highly liquid (no bid/ask spread, it's stricktly NAV based). A CEF is as more liquid that individual bonds or UITS typically, has a higher yield based on more efficient use of capital (zero cash needed in the portfolio as they have no redemption risk and can lever up when appropriate), but is more volatile that an open ended fund based on market appetite.  

LSUAlum's picture
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Joined: 2009-10-18

Spaceman Spiff wrote:LSU - explain how leveraging a portfolio right now is a positive thing.  Just thinking about the way long term bonds are going to be affected if/when the Fed raises rates, doesn't that mean that less leverage would be more beneficial?  BFP - that's exactly what I'm considering.  I've poked around on cefconnect.com enough to know that there are some better options out there for him in that same space.  If I can increase his yield, lower his duration, and capture a tax loss, I think it's a win for everyone except the IRS.  Despite the increase in long term rates recently, the fact remains they are at HISTORIC lows. Leveraging up your balance sheet when rates are low and decreasing leverage when rates are high is a fundamental financial principle to efficient use of capital. BTW the fed doesn't control long term rates. The market does. The Fed controls the short end of the curve, the market controls the long end. Short interest rates are what affect consumer and business credit costs, the long term rates are just a risk premium and implied forward rate calculation by the market.

LSUAlum's picture
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Joined: 2009-10-18

On the subject of Leverage. The way this particular fund is levered is by shorting Treasuries (12% of the portfolio is short treasuries). That is actually a boon to the overall performance if rates go up on the treasuries they have shorted. Not entirely a win/win 1:1 ratio but make leverage alot less 'scary' for some people I would hope.

Beagle's picture
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Joined: 2005-03-21

How is it that a bond fund that invests for the long term would be considered to be leveraging by selling short the same type of instruments it is long?   Per the MFS website, 99% of their portfolio is invested in muni bonds so they don't have excess LONG bonds.  With a 1.39% expense ratio, how do they generate a 6.8% current yield on the portfolio without taking massive potential default risk?  Before the expense ratio, they are WELL over 7% on tax free muni's?  How often do YOU see tax free muni's yielding over 7% that you would consider owning?JMO but we've had THE premier market conditions for bond funds over the last 20 years.  Consistently lower rates causing just about everything you own to go up in value.  That's not likely to be the case for the next 20 years.   

LSUAlum's picture
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Joined: 2009-10-18

The structure of a CEF allows a fund to buy the same exact bonds as an open ended fund and generate a much higher return. Just as an example CXH from MFS versus Pimco Total Return. This is not apples to apples by any stretch (Tax Free vs. Taxable) but just to use the CEF that we described and what is considered an extremely well run Bond Fund. CXH average credit quality is BBB vs. Pimco of A. So there is some credit quality risk, but it's not junk vs. AAA credit spreads either. The fact that CXH trades at a historical discount to NAV means that the coupon rates don't have to be astronomical to generate high returns. If you buy it at a 6% discount (historical average for this fund) then a 5% coupon turns into a 5.32% return. What about bonds they buy at a discount? Then you're getting a discount on the discount to NAV. Now, assume you have 30% leverage within the fund. That 5.32 is now 6.9%. Now assume that you have to hold almost no cash in the portfolio at any given time because you have no redemption risk. Now factor in a longer duration and effective maturity that Pimco you can see how they can achieve those types of yields without a bunch of junk credit. It's about the structure of the fund vs. an open ended fund. BTW - Pimco total return is currently leveraged 34% (net cash position is -34%).

prankeapple's picture
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Joined: 2010-11-26

This is my first post (I registered specifically because I'm terrified some poor retail investor will get reamed by dumb advice that an FA picked up on this forum). And I'm sorry to say this but LSUAlum's logic is retarded. Leveraged CEFs with high durations are a terrible idea right now. As other posters have noted, interest rates are at historic lows. The Fed is bound to begin raising the federal funds rate once one of two conditions are met: a) Unemployment declines below ~8%b) Inflation rises above the Fed's target rate of about 2%.  The consensus among economic forecasters is that at least one of these outcomes will occur within the next few years. And that's leaving out the possibility of an anxious global market allocating out of US Treasuries (hence increasing longer term rates and steepening the yield curve) because they are looking less and less 'risk free' thanks to our huge unfunded federal entitlement programs. In case LSUAlum doesn't know, when interest rates increase the value of a fixed income investment declines. When leverage is applied to this relationship, the value declines even further. Market sentiment doesn't mean crap when your NAV is down 60%. If anything, market sentiment will likely push the fund to a DISCOUNT to NAV as panicked investors exit in droves. So a 60% decline in NAV might actually result in an 70% loss in market value. Maybe you'll achieve a 20-30% tax equivalent total return over a couple years if rates stay literally at zero. But when they go up, there's no telling how much your clients will lose. And that's not a risk I'm willing to take. Especially when you consider prospect theory, which is the empirical observation that humans tend to regret losses far more than they value gains. 

Counting Crows's picture
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Joined: 2010-11-06

closed end income funds are total Witch Hazel Jedi BS.New issue closed end income funds are a 100% sure thing..........you WILL lose money for your peeps with these things for certian.     New issue closed end funds should be put in the same category as Madoff,Standford and CDO's squared.Total hose bag fee generating smaoke and mirrors garbage.You can make money for people on closed end income funds if you are smart and have balls of steel.   About every 7-10 years these things blow up because of some fear issue    Since they are supply and demand and mostly owned by peanut smaller investors.....they can get really discounted to NAV.   oct-nov 2008 was pretty close to free money.   you could buy X assets for a huge discount to NAV.    I did it.I am not being hypocritical.   Buying this Witch Doctor crap the way i did was a spec play for cleints who have a spec profile.   Not a safe, income profile like they are suppodidly designed for.  I am a big boy with eyes wide open.  thsi was not for mom and pop like you are talking about doing.these damn things shd be banned.    if it is the core part of your business then you are a jerk off con man.  Outting income peeps in these crap shoot coin flips is just wrong.How did I get so smart?    school of MF hard knocks.   Doing the same crap back in the day and getting hammered.  (ppt,min,mmt,pim etc).   You learn and adapt and try to do the right thing.You wnat income?   buy a GD bond where you know what the term,risk and income is-period.  man up,make less gross and do the right thing for people 

Spaceman Spiff's picture
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Joined: 2006-08-08

Just a follow up since I started this thread - when I called my client and asked him to come into the office to discuss what he owns, what he understands, and how comfortable he is with them, he said that he was thinking about getting rid of them anyway.  He probably said 6 times in our 45 minute meeting that he DID NOT want to see their value drop in half like they did in 2008.  We sold them and repositioned that money into several different areas.I don't do any biz with CEFs beyond what clients transfer in, but the ones I've been exposed to haven't worked out well for my clients under any circumstances.  Certainly not enough to add one more product to my mix.  I think there's enough risk out there without the products you use manufacturing it with their management style.  Maybe for a very small piece of a high yield portfolio they can be a useful tool, but as a normal part of a conservative income generating strategy, I'm not quite convinced they're a great tool. 

BigFirepower's picture
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Joined: 2010-07-09

A good general rule of thumb...Never by CEF funds as an IPO, and never buy these things when finding a decent yield is hard to come by, and you get the sense you are "chasing yield".When there is blood in the street, people are freaking out, prices crash, then CEFs can be extraordinarily cheap. If you look into the past, scenarios like that, you'll find that your eventual 18-24 mo return is twice as good with cefs, as compared to buying open ended funds. So, after 18 months, you can sell out at a nice gain, and reposition the money. A real win/win. 

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