"My financial adviser recommended a closed-end municipal bond fund (VPV) that currently pays a 7% 'dividend'. He noted that it is currently trading at a 15% discount and it's losses last year were attributed to changing federal interest rates and exposure to the Puerto Rican bond market. What are your thoughts?"
Open-end Funds vs. Closed-End Funds
The Invesco Pennsylvania Value Municipal Income Trust (VPV) is a closed-end mutual fund that provides tax-free income for PA resident investors. To understand if this is a good potential investment, it is first important to note the difference between a closed-end mutual fund and the more popular open-end mutual fund. Although there is only a one-word difference between the two options, they are quite different. Closed-end funds actually pre-date the open-end funds, and rely on an initial public offering (IPO) where a set number of shares at a specific price are sold to investors. Most of the time, investors have the opportunity to sell these investments on an exchange (such as the NASDAQ) much like a stock. Unlike an open-end fund, which trades at its net asset value (NAV), the price of a closed-end fund can vary based on the traditional forces that effect any stock (supply/demand/value of firm’s holdings). Therefore, when you are buying shares of a closed-end fund, you are actually purchasing a previous investor’s shares as opposed to simply “adding your money to the pot”. This makes closed-end funds inherently more complicated due to additional market forces that effect its price.
Closed-End Fund Puzzle
The fact that closed-end funds are able to trade at a significant discount to their total portfolio value is not well understood in the financial industry (and especially by me), but is also not sufficient reasoning to purchase an “undervalued” fund. The explanation for this mispricing uncertainty is simple – a well-off investor of a closed-end fund could buy enough of the shares (at the discounted price) and force the fund manager to liquidate the assets at the higher market price – thus resulting in a healthy profit for the well-off investor (whose profit would be the difference between the market value of the fund’s assets and the price he/she paid for the shares). So how much of a discount is necessary for an investment to be considered “safe”? That depends, but famed investor Benjamin Graham claimed that an investor can hardly go wrong by buying such a fund with a 15% discount. Because individual funds tend to always trade at either a discount or premium, it makes more sense to look at the fund’s 1-year Z-statistic as opposed to its pure discount rate. This statistic is used to compare a fund’s average discount or premium to its current discount or premium. Keep in mind that this can be misleading because it is essentially a percentage of a percentage. So if a fund trades at a 1-year average of 1% below its NAV and its currently trading at a 2% discount to its NAV, it would be trading at a 100% discount to its average discount – pretty misleading, right?
VPV’s Current Discount
The current 1-year Z-statistic for VPV is -0.15 and is most likely the number your financial advisor referenced. The fund is actually only trading at a 7.53% discount to its market value (based on the NAV calculation on 01/24/2014). This compares to its 6-month average discount of 8.51% and 3-year average discount of 3.26%. The majority of closed-end bond funds are currently trading at significant discounts to their averages due to the poor outlook of the bond markets.
State of the Bond Market Today
Keep in mind that bond investors profit from 2 things: price appreciation (the value of the bond rising or falling) and coupon payments (a.k.a. dividends). Price appreciation or depreciation does not matter at all, whatsoever, to investors who hold the bond to maturity. However, 0% of fund managers do this (at least to my knowledge). This is because they want to sell a specific issue based on changing market conditions. For example, a fund may sell bond X paying a 3.5% coupon in favor of bond Y which pays a 5% coupon. Everything else equal, any investor would choose the 5% bond above the 3.5% bond, so the fund sells bond X at a discount to its purchase price (at a loss). This is the basic reasoning behind the poor state of the bond market today – market interest rates are rising due to the Fed’s tapering of their Quantitative Easing program. This causes current bond prices to decrease as they become less favorable than new bond issues.
Other Characteristics of VPV
One benefit of closed-end funds is the ability of the fund managers to utilize leverage. Financial leverage is best described using a comparison I got from one of my finance professors – financial leverage is like alcohol; it makes the good times better and the bad times worse. VPV’s gains or losses will be magnified by its relatively-high 38.83% leverage ratio. This means that for every $1,000 the fund uses of its own money, it borrows $388.30. Another important part of any mutual fund is expense ratio. The current total expense ratio reported by the fund is 1.59% – higher than all 9 of the other funds in a 10-fund peer group made up of municipal-bond single state funds (BFO, BJZ, CMF, NCA, PCK, PCQ, NUC, NCO, NXC, VPV) (not all from PA). This is a little concerning considering it also had the lowest 1-year return versus the same 10-fund group.
7% Distribution
The 7.11% annual distribution is calculated by dividing the last share price $12.65 by the annual distribution amount ($0.075 per month x 12 months in a year). As mention under the “State of the Bond Market Today” section, the fund has 2 sources to pay this 7.11% “dividend” – price appreciation and coupon payments. Because the weighted average coupon rate of the individual bonds in the fund is only 5.64%, this distribution is only sustainable through price appreciation (a feat nearly impossible in this market). Therefore, in a best-case scenario, I would view the $0.075 monthly distribution as a perpetuity and discount it as such. This is because the fund managers will be unlikely to increase this distribution due to current market conditions, and also because the distribution has remained the same since at least 2010 (that is as far back as I can see).
Final Thoughts/Recommendation
At its current price of $12.65 and current annual distribution of $0.90, the Invesco PA Value Muni closed-end fund appears attractive with its 7.11% distribution rate (yield). While the $0.90 is likely to remain the same over the next few years, expect the fund’s price to drop as the Fed continues to taper its QE program. If you are looking for a high-dividend paying investment, I would recommend a relatively-safe/high dividend-paying stock such as Seadrill (SDRL), a real estate investment trust (REIT), or possibly another closed-end PA muni fund. However, if you do choose to invest in VPV, ensure that your distribution preference is set to “cash distribution” as opposed to “reinvest distribution”. The latter is generally the default option, but for this fund you will want to get the payout in cash as opposed to additional shares.
The Invesco Pennsylvania Value Municipal Income Trust (VPV) is a closed-end mutual fund that provides tax-free income for PA resident investors. To understand if this is a good potential investment, it is first important to note the difference between a closed-end mutual fund and the more popular open-end mutual fund. Although there is only a one-word difference between the two options, they are quite different. Closed-end funds actually pre-date the open-end funds, and rely on an initial public offering (IPO) where a set number of shares at a specific price are sold to investors. Most of the time, investors have the opportunity to sell these investments on an exchange (such as the NASDAQ) much like a stock. Unlike an open-end fund, which trades at its net asset value (NAV), the price of a closed-end fund can vary based on the traditional forces that effect any stock (supply/demand/value of firm’s holdings). Therefore, when you are buying shares of a closed-end fund, you are actually purchasing a previous investor’s shares as opposed to simply “adding your money to the pot”. This makes closed-end funds inherently more complicated due to additional market forces that effect its price.
Closed-End Fund Puzzle
The fact that closed-end funds are able to trade at a significant discount to their total portfolio value is not well understood in the financial industry (and especially by me), but is also not sufficient reasoning to purchase an “undervalued” fund. The explanation for this mispricing uncertainty is simple – a well-off investor of a closed-end fund could buy enough of the shares (at the discounted price) and force the fund manager to liquidate the assets at the higher market price – thus resulting in a healthy profit for the well-off investor (whose profit would be the difference between the market value of the fund’s assets and the price he/she paid for the shares). So how much of a discount is necessary for an investment to be considered “safe”? That depends, but famed investor Benjamin Graham claimed that an investor can hardly go wrong by buying such a fund with a 15% discount. Because individual funds tend to always trade at either a discount or premium, it makes more sense to look at the fund’s 1-year Z-statistic as opposed to its pure discount rate. This statistic is used to compare a fund’s average discount or premium to its current discount or premium. Keep in mind that this can be misleading because it is essentially a percentage of a percentage. So if a fund trades at a 1-year average of 1% below its NAV and its currently trading at a 2% discount to its NAV, it would be trading at a 100% discount to its average discount – pretty misleading, right?
VPV’s Current Discount
The current 1-year Z-statistic for VPV is -0.15 and is most likely the number your financial advisor referenced. The fund is actually only trading at a 7.53% discount to its market value (based on the NAV calculation on 01/24/2014). This compares to its 6-month average discount of 8.51% and 3-year average discount of 3.26%. The majority of closed-end bond funds are currently trading at significant discounts to their averages due to the poor outlook of the bond markets.
State of the Bond Market Today
Keep in mind that bond investors profit from 2 things: price appreciation (the value of the bond rising or falling) and coupon payments (a.k.a. dividends). Price appreciation or depreciation does not matter at all, whatsoever, to investors who hold the bond to maturity. However, 0% of fund managers do this (at least to my knowledge). This is because they want to sell a specific issue based on changing market conditions. For example, a fund may sell bond X paying a 3.5% coupon in favor of bond Y which pays a 5% coupon. Everything else equal, any investor would choose the 5% bond above the 3.5% bond, so the fund sells bond X at a discount to its purchase price (at a loss). This is the basic reasoning behind the poor state of the bond market today – market interest rates are rising due to the Fed’s tapering of their Quantitative Easing program. This causes current bond prices to decrease as they become less favorable than new bond issues.
Other Characteristics of VPV
One benefit of closed-end funds is the ability of the fund managers to utilize leverage. Financial leverage is best described using a comparison I got from one of my finance professors – financial leverage is like alcohol; it makes the good times better and the bad times worse. VPV’s gains or losses will be magnified by its relatively-high 38.83% leverage ratio. This means that for every $1,000 the fund uses of its own money, it borrows $388.30. Another important part of any mutual fund is expense ratio. The current total expense ratio reported by the fund is 1.59% – higher than all 9 of the other funds in a 10-fund peer group made up of municipal-bond single state funds (BFO, BJZ, CMF, NCA, PCK, PCQ, NUC, NCO, NXC, VPV) (not all from PA). This is a little concerning considering it also had the lowest 1-year return versus the same 10-fund group.
7% Distribution
The 7.11% annual distribution is calculated by dividing the last share price $12.65 by the annual distribution amount ($0.075 per month x 12 months in a year). As mention under the “State of the Bond Market Today” section, the fund has 2 sources to pay this 7.11% “dividend” – price appreciation and coupon payments. Because the weighted average coupon rate of the individual bonds in the fund is only 5.64%, this distribution is only sustainable through price appreciation (a feat nearly impossible in this market). Therefore, in a best-case scenario, I would view the $0.075 monthly distribution as a perpetuity and discount it as such. This is because the fund managers will be unlikely to increase this distribution due to current market conditions, and also because the distribution has remained the same since at least 2010 (that is as far back as I can see).
Final Thoughts/Recommendation
At its current price of $12.65 and current annual distribution of $0.90, the Invesco PA Value Muni closed-end fund appears attractive with its 7.11% distribution rate (yield). While the $0.90 is likely to remain the same over the next few years, expect the fund’s price to drop as the Fed continues to taper its QE program. If you are looking for a high-dividend paying investment, I would recommend a relatively-safe/high dividend-paying stock such as Seadrill (SDRL), a real estate investment trust (REIT), or possibly another closed-end PA muni fund. However, if you do choose to invest in VPV, ensure that your distribution preference is set to “cash distribution” as opposed to “reinvest distribution”. The latter is generally the default option, but for this fund you will want to get the payout in cash as opposed to additional shares.
RSS Feed