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CEF Spotlight: Muni CEFs That Could Be Worth the Risk

Steven Pikelny

With tax season upon us, many investors will soon assess their tax burdens for 2013 and promptly vow to increase the tax-efficiency of their portfolio. For taxable accounts, some will find themselves underwhelmed by the many low-yielding municipal-bond funds available to them. With this in mind, we're highlighting five Bronze-rated muni closed-end funds that are run by BlackRock and conduct identical strategies: BlackRock MuniVest (MVF), BlackRock MuniVest II (MVT), BlackRock MuniYield (MYD), BlackRock Municipal Income (BFK), and BlackRock Municipal Income II (BLE). To be sure, these are high-octane muni funds, and are certainly not for every investor. But for the most aggressive, they are definitely worth a look.

BlackRock's municipal team runs more than $100 billion in assets. Walter O'Connor and Theodore Jaeckel head the firm's municipal mutual funds, with Jaeckel focusing on its CEF and high-yield muni vehicles, and O'Connor focusing on the open-end and California-driven strategies. O'Connor and Jaeckel first joined Merrill Lynch Investment Management in 1991 and 1990, respectively, before making the move to BlackRock when the firm purchased MLIM in October 2006. We like that Jaeckel owns $100,000 or more in shares in each of BlackRock MuniVest, BlackRock MuniVest II, BlackRock MuniYield, and BlackRock Municipal Income, which aligns his interests with shareholders'.

The managers are supported by an expansive muni-credit analyst staff led by Jim Schwartz, who also joined MLIM in 1990. The credit research team consists of 16 analysts, 11 of whom have well over a decade's worth of experience (17 years, on average). They're also supported by a three-person risk and quantitative team. Overall, this fund is supported by one of the largest and most experienced muni teams in the industry.

These funds are designed to generate high levels of federally tax-exempt income and are therefore typically more aggressive than their open-end peers, and many of their closed-end peers. The funds invest in long-duration debt, employ above-average quantities of leverage (by CEF standards), and are free to invest up to 20% of assets in non-investment-grade securities.

From a top-down standpoint, the funds take their interest-rate cues from BlackRock's investment committee. However, the managers generally stick to longer-duration bonds. While BlackRock does not publish detailed maturity data for their muni CEFs, BlackRock National Municipal (MANLX) reports that more than half of its assets are invested in securities that mature in 20 or more years. Taken along with the leverage, it's safe to assume that the CEFs carry a significant amount of interest-rate risk.

On the credit side, managers lean on their extensive credit research team. Within this group, some analysts also serve on a credit oversight team to help manage portfolio risk and keep watch over securities' credit quality. The team currently favors revenue-backed debt, including transportation, utility, and health-care bonds. As with all of BlackRock's funds, this portfolio is run through a risk and quantitative analysis system, which is managed by a separate team; this system highlights portfolio risks and allows managers to conduct scenario analysis.

On average, these five funds carry a leverage ratio (total assets/net assets) of 1.65, which is notably higher than the muni CEF peer group's 1.50 average. Leverage financing for each fund is split between various forms of variable-rate preferred shares and tender-option bonds (TOBs). Because both forms of leverage are variable rate, an increase in short-term interest rates would also increase leverage costs. Depending on the final implementation of the Volcker Rule (scheduled to go into effect July 2015), banks and affiliates may no longer be able to sponsor TOBs, which could constrain the market for such securities. In such an event, managers note that they likely would use preferred shares exclusively.

Over the long haul, this aggressive approach has generally led to above-average returns on a net asset value basis. During the trailing decade, the funds easily posted returns in the top quintile of the leveraged municipal CEF peer group. However, the funds are vulnerable to steep losses when muni yields spike. Amid rising interest rates in 2013, four of the five funds logged significant losses, ranging from 7.6% to 9.4% on a NAV basis.[1] Meanwhile, the average leveraged municipal peer only lost 7.3%. As a result, although published durations suggest that these funds are less sensitive to rising rates than many of their peers, it's clear that there is significant interest-rate risk in these portfolios. Moreover, share-price performance was even worse, as discounts widened over the period.

Fees and Alternatives
The funds' total expense ratios (which include the costs associated with leverage) ranged between 1.52% and 1.71%, compared with the 1.53% average for leveraged municipal CEFs. While these expenses are just middling, the funds become more attractive after taking into account their discounts as of early March 2014. The discount increases their distribution rates at share price and decreases their carrying costs. (We discuss carrying costs more here). Considering that the five funds maintain nearly identical strategies, BlackRock MuniYield is the most attractive, in our opinion, with an annualized carrying cost of 1.21%. Depending on the movement of future discounts, investors might want to consider one of the other four funds.

BlackRock MuniYield Quality III (MYI) is another attractive option and is managed by the same team. This fund has an even lower carrying cost of 0.96%, driven by its wide discount and lower total expense ratio. In addition, this fund does not have the ability to invest in junk-rated debt; hence, it carries less credit risk. Overall, investors don't give much up in the way of income, either. With an earning rate of 7.1% at share price, this fund actually generates one of the highest levels of income in BlackRock's municipal CEF lineup. The fund's distribution rate at share price, reflecting income actually paid out, is slightly lower at 6.7%.

[1] MVF was the exception, losing only 6.3%. This fund altered its mandate in mid-2013, such that it could invest in similar levels of non-investment-grade securities to its sister funds.

Steven Pikelny does not own shares in any of the securities mentioned above.