New York, NY – Municipal closed-end funds (CEFs) have experienced significant upheaval in their distribution strategies in recent months, with many fund managers quickly implementing substantial and repeated distribution increases. These moves are primarily seen as responses to pressure from CEF activists targeting the sector. The objective behind these increased distributions is to narrow discounts, a strategy that CEF managers hope will deter activist investors.
Since longer-term interest rates rose sharply in 2022 and credit spreads tightened, there has been a positive outlook on municipal bonds. The recent distribution hikes by CEF managers introduce a new tactical element, where it is anticipated that municipal CEF discounts will either perform well relative to other sectors during market downturns or tighten in stable market conditions.
The favorable combination of strategic and tactical factors has prompted a decision to increase muni CEF holdings in the Municipal Income Portfolio. Additionally, there are positive tactical considerations to note, including historical data showing positive returns between Memorial Day and Election Day, particularly for higher-rated bonds.
Furthermore, the competitive current yields of many muni CEFs compared to other sectors, offering yields around 7-8%, are appealing, especially on a tax-equivalent basis for high-rate taxpayers. This attractive yield, albeit partially due to return of capital (ROC), is expected to draw investor capital from taxable sectors, benefiting higher-yielding funds in the municipal bond sector.
On the fundamentals side, improvements are evident as upgrades continue to outpace downgrades. There has been a 1.5% year-on-year increase in median tax collection growth through April, with personal income collections up by 2%.
Municipal credit spreads are currently at low levels, reflecting a broader trend in the credit market. Despite tight spreads, the relatively high nominal and real yields support an allocation to longer-duration assets like municipal bonds. Municipal bonds are favored for their quality, which tends to provide resilience during market downturns.
The recent surge in distributions by various muni CEF managers, driven in part by activism in the sector, has not yet translated to tighter discounts as expected. However, the higher yields offered by these funds are likely to attract demand from investors who typically do not venture into municipal CEFs, potentially leading to narrower discounts in the future.
Based on these market dynamics, adjustments have been made to portfolios, emphasizing positions in CEFs that have recently increased distributions and continue to trade at wide discounts. Notable additions include the Western Asset Managed Municipals Fund (MMU) as well as upsized positions in Nuveen CEFs.
In conclusion, the municipal bond sector remains attractive for its high nominal and real yields. This attractiveness is reinforced by the expensive credit market and the comparative advantage of municipal bonds during market shocks. Municipal CEFs with recent distribution hikes present a tactical opportunity, with the potential for increased demand and tighter discounts.
