Weekly Review: Municipal Bond CEFs - PCQ Almost Reached 40% Premium

A slight decrease in the price of the benchmark after the distributed dividend and the stronger monthly jobs report.The 10-year Treasury note yield rocketed back above 2.00% on Friday.We continue to follow the most important yields and municipal/Treasury spread ratio.Most of the funds from the sector are traded at positive Z-scores, and we do not see a statistical edge to include some of them in our portfolio.Over the past few months, most of you have noticed our increased activity in closed-end funds as the inflow of volatility finally shook them up and created various arbitrage and directional opportunities for active traders like us.Currently, we are cautious when we choose our long positions, as most of the closed-end funds which hold municipal bonds have lost their statistical edge and are traded at positive Z-scores. However, there are several interesting pair trade opportunities which can be traded. For the conservative market participants with a longer investment horizon, I still see interesting dividend opportunities which are traded at high discounts.A shorter week and relatively low trading volume in the municipal bonds. The factors which affected the bonds were mainly the distributed monthly dividend and monthly jobs report. On Friday, the 10-year Treasury note yield climbed back above 2.00% after the government’s monthly jobs report showed much-stronger-than-expected employment growth in June. I think the real problem here for the investors was the possibility to not see a dividend cut in July as some of them anticipate.On a weekly basis, the main index, the iShares National Muni Bond ETF (MUB), decreased its price by $0.15 and finished the Friday session at $112.94 per share. It is important to mention that the ex-dividend date of the main index was on Monday, and it distributed a monthly dividend of $0.2290 per share.

As you know, we follow the performance of the U.S. Treasury bonds - considering them a risk-free product - with maturities greater than 20 years: the iShares 20+ Year Treasury Bond ETF (TLT). The reason for that is the strong correlation between these major indices, and the chart below proves it. Additionally, a statistical comparison is provided by our database software:

Investing in municipal bonds is popular because they have the potential to offer higher yields than similar taxable bonds. If an investor wants to know whether muni bonds are cheap in comparison to taxable bonds or Treasuries, they could find out by comparing them. However, this method does have its limitations, and the investor should perform a more thorough analysis before making a decision:

The Municipal/Treasury spread ratio, or M/T ratio as it is more commonly known, is a comparison of the current yield of municipal bonds to U.S. Treasuries. It aims to ascertain whether or not municipal bonds are an attractive buy in comparison. Essentially, an M/T ratio north of 1 means that investors receive the tax benefit of muni bonds for free, making them even more attractive for high net worth investors with higher tax rate considerations.

The narrowing spread and 3-month LIBOR are important for the leveraged municipal funds, and they can be highly affected by them. The 3-month LIBOR rate is a commonly used funding benchmark for the municipal bond CEFs.

Data by YCharts

Over the past week, several funds announced their regular dividends:1. Biggest price decrease

2. Biggest price increase

1. Lowest Z-Score

Sorting by the lowest Z-scores, we find out that we cannot talk about a statistical edge in the sector. It is an appropriate indicator to see how many times the discount/premium deviates from its mean for a specific period. As you notice, only six of the funds provide us with negative Z-scores.The Pioneer Municipal High Income Advantage Trust (MAV) continues to be the most undervalued fund based on the statistical approach with its Z-score of -1.10 points. The price of MAV dropped after the announcement of a new dividend cut.

It is very interesting to find PIMCO funds in the table. The PIMCO New York Municipal Income Fund II (PNI) is taking the second position in the ranking after its price remained in negative territory with 1.03% on a weekly basis. On the other side, its net asset value reported an increase of 0.26%. The situation around one of the other New York municipal bond closed-end funds of PIMCO is very similar. The price of the PIMCO New York Municipal Income Fund III (PYN) was among the worst weekly performers, and it is traded at a Z-score of -0.60 points.I continue to follow the performance of these PIMCO funds, and if their prices continue to fall, I may review them as potential "Long" candidates. It is not a very common situation to have an opportunity to buy PIMCO funds at their net asset value or at discount.2.Highest Z-Score

Аbove are the closed-end funds sorted by their highest Z-score. From a statistical point of view, they should be overpriced. In the current market environment, when the sector is very strong and we may see interest rates cuts, it is very difficult to say which of the munis are overpriced. Yes, the Z-scores are high, but they are still traded at discounts. My simple recommendation is to play the game smart, and when some of your long positions are traded at a Z-score above 2.00 points, close them and buy some of the funds which have a lower statistical parameter. The risk/reward ratio is not in your favor when you hold statistically overpriced funds.Аnother very important point which I would like to highlight is the topic of the earnings and the dividends. In other words, how to avoid "dangerous" funds which can decrease their dividend. The easiest way is to monitor the earning/coverage ratio and the UNII/share balance. If both of them become negative for several consecutive periods, the dividend cut seems a very realistic event.Let us take the Invesco California Value Municipal Income Trust (VCV), for example. It has a Z-score of 2.20 points, and I suppose most of the market participants buy it at the current price due to its yield of 4.44%. If you check the latest earning per share, you will notice that it is not high enough to cover the monthly dividend. On top of that, the UNII/share balance is negative. All the prerequisites to see dividend cut very soon. So, from each angle, the closing of your long position in VCV seems the right choice.

The average one-year Z-score in the sector is 1.11 points. Last time, the average Z-score of the municipal sector was 1.17 points.

3.Biggest Discount

Over the past week, only the Invesco Trust For Investment Grade New York Municipals (VTN) reported a decrease in its net asset value. The rest of the funds increased their net asset values. Тhe more important fact is that compared to the previous time, we do not see significant changes in the discount/premium metric of the municipal bond closed-end funds.The Delaware Investments Minnesota Municipal Income Fund II (VMM) is the new leader of the ranking and the only participant that has a discount above 13.00%. If you want to extend your investments in Minnesota, then VMM may catch your attention. The current yield of the fund is 3.50%, and the dividend is fully covered by the latest earnings. The credit quality of VMM is more than impressive, as 43.79% of its investments are rated "AA".

4.Highest Premium

Recently, this section has been devoted to the PIMCO California Municipal Income Fund (PCQ). It is impossible to miss the performance of this fund. Аfter the announcement of the unchanged dividend, the price of PCQ rose by 4.28% and closed at $19.47 per share. Pretty soon, we can see this fund traded above at a 40.00% premium. It is unnecessary to say that I strongly recommend staying away from a long position in this fund.

The average discount/premium of the sector is -5.60%. Last time, the average spread between the prices and the net asset values of the funds was -5.63%.

5. Highest5-year Annualized Return On NAV

The above sample shows the funds which outperformed their peers. The average return on net asset value for the past five years for the sector is 5.40%.Аlthough PIMCO funds are one of the best performers, the Eaton Vance Municipal Income Trust (EVN) achieved a higher return on its net asset value. This closed-end fund is still traded at a 9.16% discount, and its Z-score is relatively low. If the historical performance of the fund is important for you, you will want to review EVN as a potential candidate for your portfolio.6.Highest Distribution Rate

The average yield on price is 4.25%, and the average yield on net asset value is 4.02%. An important notice that I would like to make here is to be rational and to include the earning/coverage ratio to your analysis. Some of the market participants invest in the funds which pay higher yields, but they do not take into consideration the risk of a potential dividend cut if the dividend is not covered by the earnings.The Nuveen Municipal High Income Opportunity Fund (NMZ) is a fund which caught my attention in a positive way. It offers a 5.08% current yield, and its dividend is fully covered by the earnings. On top of that, the UNII balance per share is in green territory.

7.LowestEffective Leverage %

The average effective leverage of the sector is 36.1%. Logically, most of the funds with lower effective leverage have lower distribution rates compared to the rest of the closed-end funds. Seven funds from the sector have effective leverage equal to zero.Compared to the previous years, the discounts of the closed-end funds holding such products have significantly widened, but we remain cautious when we select our long positions due to the high Z-scores in the sector. However, there are several interesting pair trades which you can review.I/we have no positions in any stocks mentioned, but may initiate a short position in PCQ over the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.