Analysts Slashed Ratings on Municipal Bond Funds
Five Municipal Bond Funds Gets “Sell” Rating
Income investors are no stranger to municipal bonds. However, a major financial services firm just warned about the risk in closed-end funds (CEFs) of municipal bonds.
On Monday, August 15, Stifel Nicolaus analysts Alexander Reiss and Nick Cunningham cut their ratings on 17 different municipal bond closed end funds. Some of them, such as Nuveen California Dividend Advantage Municipal Fund (NYSE:NAC), Nuveen Massachusetts Premium Income Municipal Fund (NYSE:NMT), and Invesco Advantage Municipal Income Trust II (NYSEMKT:VKI), were given “Sell” ratings. (Source: “Municipal Bonds: Time to Dump Those Closed End Funds?,” Barron’s, August 15, 2016.)
“The decline in long-term bond yields has amplified a search for yield,” the analysts wrote. “This has helped to fuel a rally in municipal bonds and even more so in the closed-end funds that own them.”
To be more specific, Reiss and Cunningham noted that the average municipal bond fund has generated a 6.68% net asset value (NAV) total return so far this year. The share prices of municipal bond funds have gained an average of 12.96% during this period.
The NAV return is the change in the net asset value of the fund. The NAV return of a fund can be different than the total return that investors realize because the funds can trade at a premium or a discount to the value of the assets held in the portfolio. This time, the rally in municipal bond funds seems to be much bigger than the rally in the bonds they hold.
According to Reiss and Cunningham, one of the catalysts behind the rally in those funds was uncertainty. Historically, the strong credit quality of municipal bond funds’ portfolios have provided defense against economic turmoil. Now, with lackluster economic growth and the recent Brexit vote result, these funds have gained renewed interest from investors.
“This run-up has made municipal funds less attractive in our eyes as potential headwinds begin to strengthen,” the analysts wrote. “Since markets tend to focus on ‘better’ or ‘worse,’ we believe several intensifying headwinds have the potential to lower near-term forward returns.”
Reiss and Cunningham listed three reasons why municipal bond funds have become less attractive this year: “1) bond portfolio holdings trading at premiums to par value, 2) shrinking fund shares price discounts to NAV, and 3) declining portfolio earnings and potential distribution cuts.” (Source: Ibid.)