Closed-End Muni Bond Funds Are Cutting Their Payouts

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At a time when bond yields have risen, many municipal bond closed-end funds (CEFs) are doing the opposite of what their shareholders would expect. These funds are cutting their distributions.

Bloomberg says that PIMCO recently cut distributions on 17 muni CEFs. The monthly payout on the PIMCO California Municipal Income fund (PCQ) was slashed by 45%. Invesco, Nuveen and Eaton Vance have also lowered their distributions. The Wall Street Journal counts six BlackRock muni CEFs that have endured cumulative distribution cuts by as much as 38%. 

These payout reductions are occurring even though buyers of muni bonds are getting a larger income stream on the dollars they invest now than they did a year ago. Leverage is the culprit.

CEFs issue a fixed number of shares. They are not able to adjust their share count in response to rising or waning investor interest the way mutual funds or exchange-traded funds (ETFs) can. As Matthew Crouse explained in the AAII Journal, the closed-end structure makes it easier for CEFs to borrow money against their asset base.

In general, rising interest rates benefit lenders and hurt borrowers. Bondholders are lenders, as they give bond issuers a sum of money for a fixed period of time in exchange for a series of interest payments. Users of leverage are borrowers. Leveraged muni bond CEFs attempt to play both roles by borrowing money to buy more bonds. As long as bond yields are higher than the leverage rates, this can be a good strategy.

Leverage rates have gone up, while the coupons (interest payments) on existing bond holdings have remained steady and the prices of those bonds have declined. While closed-end fund managers could sell bonds with lower coupons and buy newer bonds with higher coupons, there is a mismatch between the proceeds received from the sale of the lower coupon bonds and the costs of the higher coupon bonds. (A current buyer is not going to pay the same price for a bond with a lower coupon when a higher coupon offering of the same credit quality is available.) Since there aren’t inflows of new investor dollars due to the closed-end structure, plus there are limits on the extent to which leverage can be used and it is now more expensive to use leverage, leveraged bond CEFs are caught between a rock and a hard place.

To paraphrase a line from Warren Buffett, shareholders in these leveraged CEFs are learning who has been swimming naked now that the tide has gone out.

More than two-thirds of the CEFs listed in the Closed-End Fund Center’s database use leverage. Leverage can work when it is strategically used. It can backfire in a big way when conditions turn against a strategy.

Closed-end funds can borrow up to $1.00 for every $1.00 of net asset value (NAV) if using preferred stocks and up to $0.50 for every $1.00 of NAV if using debt. Investors interested in these funds would be prudent to look for CEFs that are not overly aggressive with their use of leverage and are trading at (deep) discounts to their NAV.