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Should I Invest in Pennsylvania Municipal Bonds?

Posted by Kevin Means, CFA on Jun 20, 2019 8:45:00 AM


An earlier article discussed the basic considerations for investors contemplating an investment in municipal bond funds.  National Muni Bond ETFs provide a low-cost and simple way to invest.  However, municipal bond closed-end funds (CEFs) are sometimes a more attractive way to invest in the space when they are trading at an unusually large discount to the net asset values of their portfolios.  Written specifically for Pennsylvania taxpayers, this article compares what we consider to be the most attractive Pennsylvania municipal bond mutual funds and CEFs to national ETFs and CEFs.          

Pennsylvania Income Taxes.  Interest on municipal bonds is not subject to federal income tax.  In addition, most states do not tax interest on municipal bonds issued by municipalities within their own state, including bonds issued by the state itself.   Pennsylvania  (PA) has a flat income tax rate of 3.07%. The purpose of this article is to compare the relative attractiveness of national muni bond funds and PA muni bond funds for PA investors.  To make fair comparisons, the yields for the PA-specific muni funds have been grossed up by 3.07%.      

Pennsylvania Muni Mutual Fund.  Vanguard Pennsylvania Long-Term Tax-Exempt Fund (VPAIX) is a mutual fund that invests in Pennsylvania municipal bonds.  It is actively managed but keeps very close to its benchmark index, the Bloomberg Barclays PA Muni Fund Index.  Its expense ratio is a very competitive .17%.  As of May 31, 2019, VPAIX had a yield of 3.25%.   Grossing up the yield by 3.07% results in an adjusted yield of 3.35%.   The fund’s duration is 4.8.  This mutual fund is easily our favorite PA muni mutual fund because it is managed nearly like an index fund, captures the PA muni market well, and has an extreme low expense ratio compared to competing funds.        

Pennsylvania Muni Closed-End Fund.  Currently, our favorite Pennsylvania municipal bond CEF is Nuveen Pennsylvania Municipal Value Fund (NPN).  Here are the reasons we like it:

  • High expected residual return using our proprietary CEF return forecasting model
  • Relatively low duration (interest rate risk) of 3.5
  • 7% discount to net asset value (NAV)
  • Attractive distribution yield of 3.51% (3.62% after adjustment)
  • Low leverage of only 4.4%
  • Low expense ratio of 1.02%

National Muni ETFs.  For comparison purposes, we include the two very large and liquid low-cost national municipal bond exchange-traded funds (ETFs) that we have highlighted in past articles:  iShares National Muni Bond ETF (MUB) and Vanguard Tax-Exempt Bond ETF (VTEB). Both are passively-managed index funds based on the same benchmark index, S&P National AMT-Free Municipal Bond Index, so their characteristics and holdings are highly similar.  In order to define the muni yield curve, we also include iShares iBonds Sep 2020 Term Muni Bond ETF (IBMI) to represent the short end of the national muni market. 

National Muni CEF.  In addition, for comparison purposes we also include our current favorite national muni CEF, AllianceBernstein National Municipal Income Fund (AFB).  Like most national muni CEFs, AFB has a much higher duration than the two core national ETFs, VTEB and MUB.

 

 

Yield/Duration Comparisons.  As is evident from the graph above, there is clear a benefit to PA investors in utilizing a PA-specific fund to avoid PA income tax.  Compared to the two national muni ETFs (VTEB and MUB), VPAIX and NPN both have a combination of higher yield and lower duration.  In this regard, NPN is more attractive than VPAIX.   Both also appear more attractive from a yield/risk standpoint than the national closed-end fund AFB.  Although AFB has a higher yield, its duration is so much higher that it appears merely to lie on the same curve as the two national muni ETFs, whereas NPN and VPAIX are clearly above it. 

NPN’s NAV Discount.  On May 31, 2019, NPN’s NAV was $15.17, and its price was $13.85, so it was trading at an 8.7% discount to NAV  ([15.17-13.85]/15.17). That’s $15.17 in value for a price of $13.85.  The value of that NAV is rock solid.  AFB’s portfolio is not subjective or difficult to price.   It consists of publicly traded municipal bonds.  Even if the NAV discount never goes away, the investor benefits from the economic value, and cash flow generating capability, of the full $15.17.  If AFB were trading at its NAV of $15.17 on May 31, 2019, the distribution rate would have been 3.20% (.0405 x 12 / 15.17) instead of 3.51%.  That’s an additional .31% in yield just from buying on the cheap! 

Sapient’s Proprietary CEF Return Factors.  Up to this point, all of the information we have cited is generic, publicly available information.  What sets us apart is what comes next. At Sapient Investments, we use sophisticated quantitative analysis to forecast the expected returns of every closed-end fund in the U.S.  We look for a combination of value and momentum characteristics. 

Value Factor:  NAV Discount.  We can’t go into detail about all of our proprietary factors.  However, we will do a quick deep dive on the one we consider most important:  NAV Discount.  Buying a CEF at a price below the NAV of its portfolio is clearly a value strategy.  Our research indicates that the NAV discount factor is the single most powerful CEF selection factor in our arsenal.  The graph below illustrates one of our research tests for this factor.  We begin our test at the end of 2012, when NAV data first became available in FactSet.  At the end of each month, we form a “Top 5” portfolio of the five CEFs with the largest NAV discounts.  Each has a 20% weight.   We calculate the residual return of this portfolio during the month and then re-select and rebalance the “Top 5” portfolio at the end of the next month, and so on.  Similarly, at the end of each month we also form a “Bottom 5” portfolio of the five CEFs with the smallest, or most negative, NAV discounts, re-selecting and rebalancing monthly.

 

 

Other Factors.  The graph above depicts the test for only one factor:  the simple NAV discount.  In addition, at Sapient Investments we use several other factors to forecast the residual returns of CEFs.  Our research indicates that even more powerful than the simple NAV discount are variations that compare the current NAV discount to the historical average discount for that CEF, buying only those with an unusually large discount relative to that CEF’s own history.  Also, changes in distribution amounts are quite powerful in the short run.  And mean reversion in long-run (3, 5, and 10-year) total return is a very effective value indicator.  Finally, 12-month NAV return momentum is helpful as well. 

Overall Model.  Below we present test results for our overall return forecasting model within the national closed-end muni fund universe.  This includes the effects of all of the factors we use to forecast residual return as well the effects of systematic return factors, including the distribution yield.  The blue line is the cumulative log of total return (not residual return) of an equal-weighted portfolio of the five single-state muni CEFs with the highest total return forecasts, rebalanced monthly.  Since 2012, the average log of total return has been 9.0% per year on average.  The orange line is the same thing but investing in the five with the lowest (or most negative) total return forecasts.  That return has been -8.7%.  The green line is a long-short implementation of the strategy.  Its return has been 17.6% per year.  The results have been both strong and consistent, on both the long side and the short side.

 

 

NPN’s Total Return Forecast.  As of May 31, 2019, NPN had the highest alpha forecast among the PA CEFs in our universe.  NPN has a powerful combination of extremely attractive value, as reflected by its unusually large NAV discount of 8.7%, and return momentum that is well above average.  Primarily driven by these factors, our overall model indicates that we can expect an additional .20% return over the next month.  If sustained, this would annualize into a 12-month risk-adjusted return forecast of 2.43% (shown in dark brown below).   Combined with NPN’s distribution yield of 3.62% (in orange below), this translates into an expected tax-free total return of 6.05% (3.62% yield + 2.43% price change).  This is particularly attractive given AFB’s relatively low level of interest rate risk (duration).  

 

 

Superiority of CEFs.    We have already seen that the PA mutual fund, VPAIX, and the PA closed-end fund, NPN, are more attractive than the core national muni ETFs, VTEB/MUB from a yield/risk standpoint.  The graph below provides a comparison of their total return/risk tradeoffs.  Because of our proprietary CEF alpha forecasts, the two CEFs are clearly superior to the ETF and mutual fund alternatives.

 

 

Choice Depends on Interest Rate Outlook.  This picture is somewhat similar to the yield/risk tradeoffs.  NPN (a PA CEF) is clearly very attractive on the basis of total return/risk.  AFB (a national CEF) has a much higher total return forecast, but its duration is also quite a bit higher.  The choice between NPN and AFB may come down to the level of interest rate risk preferred, and an investor’s outlook on changes in interest rates.  Investors who believe interest rates are likely to increase in the future will prefer NPN.  Investors who believe that interest rates are more likely to fall further will prefer AFB. 

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