Municipal bonds should be an important part of any US investor’s portfolio. They offer a small pickup over US treasuries (usually due to the lower rating of the issuer) and most importantly they offer tax free returns on the interest earned. Treasuries, although they do avoid state and local taxes on interest earned, are still subject to federal income tax. In New York City, municipal bonds are even more attractive to residents here because they avoid federal, state and local city taxes.
However in this low interest rate environment, with 10 year notes for New York State municipal bonds yielding 2.65%, the returns are paltry. In the early 2000’s though, Wall St. devised a way to get around these boring returns with a few innovations that juiced the yield through what are called closed end funds. They were able to produce new closed end funds that focused on particular sectors of the bond market, high yield, corporate bonds and even municipal bonds. These closed end funds offered returns that were many times double what the market rate yield was on the underlying debt. Pimco started a number of these funds that are still traded on the NYSE and are available to any investor. For example Pimco has 3 New York municipal bond closed end funds, one of which offers a yield of 6.59% right now. But what are closed end funds and how do they achieve these type of returns?
Closed End Funds
The first step is to understand what a closed end fund is. A closed end fund issues equity and this equity is fixed, unlike with a typical IPO of a corporate issuer which can return and reissue whenever they want. Investopedia provides a simple definition of what the closed end fund is:
Like a mutual fund, a closed-end fund is a pooled investment fund with a manager overseeing the portfolio; it raises a fixed amount of capital through an initial public offering (IPO). The fund is then structured, listed and traded like a stock on a stock exchange.
So now we know 2 important features; it has fixed capital and a manager.
AS we will see, this equity is then used to create a portfolio, in this case a portfolio of bonds. Now the market price for the equity can swing whichever way the stock market takes shares but the underlying portfolio will move with the bond market. This can create a disparity between the value of the underlying portfolio and the value of the listed shares. The value of the equity of the portfolio is called the net asset value (NAV) and the shares price listed on the exchange can either be at par, at a premium or at a discount to the NAV of the underlying assets.
Diving Into PNI
For our particular example, and since I am concerned with municipal bond funds in this post, I am going to focus on closed end funds for municipal bonds. Specifically I would like to dive into the Pimco NY Muni Income II (PNI)) which currently offers the 6.59% yield which I mentioned previously to figure out how the fund works so that we can assess the risks and return profile of these types of funds.
Pimco provides a profile page for the fund with a picture of a smirking Mr. David Hammer, the fund’s manager, to reassure us. Below that they give us some important statistics about the fund. We can see that the NAV yield is even higher than the market yield at 6.94% on a monthly basis and the effective maturity is 9.84 years. This means that the underlying portfolio is most comparable to a 10 year NY municipal bond. It also shows the leveraged adjusted effective duration. Meaning after accounting for the effects of leverage, a 1% change in interest rates will mean a 11.55% change in the value of the portfolio, meaning this portfolio is very sensitive to interest rates.
Moving further down we can start to deduce the source of these outsized yields: leverage. The total effective leverage of the fund is 40.73, meaning 40.73% of the value of the current portfolio is debt. 90.6% of this debt consists of preferred shares and 9.4% consists of floating rate notes.
And that is essentially where the fund stops readily supplying us with information. There are no notes provided for the footnote numbers next to the leverage figures. It took some digging on my part to figure out how exactly these preferred shares are structured and what they are paying to figure out exactly how the leverage works for this closed end fund.
Down the ARPS Rabbit Hole
Using the annual report and some more help from the internet I was able to find out that the preferred shares used for this facility were ARPS, which stands for Auction Rate Preferred Shares. There is a bit of history behind these types of shares that is linked back to the financial crisis.
As Pimco explains here ARPS were perpetual preferred shares that are senior in the capital structure to the common shares that you and I can buy. They were perpetual meaning they will never be bought back but they will always pay the holder of these shares a dividend. In fact the dividend on these shares is weekly. ARPS trade in weekly auctions designed to attract buyers. The dividend rate is reset during a successful auction and is influenced by supply and demand factors as well as the ARPS’ issuer’s credit rating. Although the underwriter is under no obligation to participate in the auction, prior to 2008, the underwriters typically bought all of the ARPS and sold them on to other investors as short term debt. Then in 2008, the short term credit markets seized up and the auctions started to fail and fail and…….wait, they are still failing to this day 8 years later. So when an auction fails, a fallback method kicks in to determine what the rate the payment on the shares would be. This was called the “max rate”. The funds have been paying this max rate ever since the crisis and on the same security overviews page it has a link to current max rates for all of the closed end funds it currently runs.
We can see here that the rate is the higher of the 30 day “AA” Composite or Commercial Paper Rate or The Taxable Equivalent of the Short Term Municipal Obligations Rate, multiplied by 110%.
So what the heck are these? Well these are basically the short term funding rates of AA rated borrowers who issue commercial paper (short term debt under a year in tenor) or a similar short term paper rate for municipal borrowers. Both of which, retail investors may have a hard time accessing. However another way to find the answer to how much is being paid is to dive into the annual report.
Before we do that though it is worth pointing out that paying these max rates likely are at payment levels that exceed what the fund was paying for short term debt before the financial crisis when the ARPS market (if you want to call it a market) was functioning. Now they have been locked into permanently higher costs, which explains some price history of these securities. After a big drop in 2008, the market price never recovered to its pre 2008 high and this is likely the reason for that. The fund is stuck paying higher rates for the debt it issued and can’t get back the spread it once had on the yield of long term debt it was receiving and the short term debt it was paying (see below).
What You Get Now After Costs
So we have 2 things going on overall with this fund, the fund is getting the interest payments on municipal debt, then paying a its preferred shareholders and a management fee and the shareholders get what is left (after some trading and other minor costs). As a percentage of assets what is the yield on the assets looking like and how does that compare to what the fund is paying?
To find the answers to these questions I dove into the latest annual financial statements (2015). The information was presented pretty poorly so I took the liberty of summarizing the PNI information here:
After examining the assets, liabilities and income it became clear to me that something was missing. Gross investment income over investment securities was only yielding 4.72% and after management fees was 3.9% of investment securities. The common shares at a price of $12.27 a share on market close of May 31 2015 were yielding 6.45%. Additionally the information regarding the payment of the preferred shares was missing.
Pimco is clearly only reporting the interest income from the bonds NET of the payments to preferred shareholders. There was nowhere in the income statement where Pimco was reporting the total payments to the preferred shareholders nor the gross interest income. Going into the notes, the best source I could find was the high and low rates of the preferred shares and the rates as of December 31, 2015.
Since no gross interest was reported on the municipal bond portfolio, in order to get an idea of the spread of gross interest to the payment of preferred shares I would recommend using the 10 year yield on NY State municipal bonds and subtracting this by the higher figure reported for the interest rates on the short term ARPS .
An example would be the 10 year yield being 3.00% and the ARPS rate being 0.43% the income before expenses available to shareholders would be the net 2.57% on the invested portfolio, which at leverage of 40.73% would yield about 4.36%.
I find this to be an ingenious strategy to offer leveraged municipal bond investments to the public. Some investors may prefer the high income and greater volatility. One reason for this is that you would be able to sell in bad years and book losses for tax purposes on the principal investment and when you buy back in, be able to pay the taxes on the gain in price at a later time.
However Pimco does not disclose enough information about the real heart of the securities. There should be more information available to common investors in order to be able to properly gauge the risks of the investment and the strategy which is essentially to use short term leverage to buy long term assets.
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