DGI Adventure 08-03-16 – Fixed Income Fund Watch List Part 4 of 3 – CA Municipal Bond Funds

In May I published parts one and two of my research into fixed income Closed End Funds (CEFs). I meant to publish part three that month as well, but I didn’t put it up until July.

Little did you know that I was secretly working on a part four!

Well maybe you did know. If you check in regularly at the mothership, you will know that all of my watch lists are published there, and you may have noticed the latest tab in the google sheet titled “Fixed Income – CA Muni Bonds”

“What’s that all about?” You probably wondered aloud.

Well wonder no more.

Municipal bonds are pretty neat. They’re neat because as an investor, you don’t owe federal income tax on the interest you receive. I suppose the thinking goes that if private investors didn’t help local governments pay for projects, the federal government would and it would come out of your taxes anyway? Not sure, but “muni bonds” as they’re affectionately referred to are a great part of any tax diversification strategy. Like any type of bond, I don’t feel that I have the time, patience or capital to adequately diversify into a well rounded portfolio of individual issues. So that means mutual funds or ETFs.

Once again, I prefer CEFs here because the muni bonds tend to have relatively low liquidity. I don’t want the fund manager being forced into selling low just to meet scared investors’ redemption requests during a tough time in the market.

As a resident of the great and expensive state of California, I also pay outrageous state income taxes on top of my outrageous federal income taxes. If I invest in muni bonds in Indiana, I enjoy a federal tax exemption on the interest, but California will still want hers. However, if I buy bonds in California, I don’t owe any state or federal income tax, because the state offers the same income tax deal as the Feds.

Okay…so CA muni funds sound super neat. Why look into them now?

I recently refinanced our mortgage. The payment is ~$430 less per month as a result. On top of that, I was paying an additional $300 per month of equity to bring down the principal, so our cash flow has experienced a net ~$730/month bump.

Rather than go out and lease a brand new Lexus, we intend to save the difference. The whole point of refinancing was to SAVE money. Not SAVE money and then IMMEDIATELY SPEND it!

I thought about continuing to pay down principal with the extra cash, but frankly the interest rate is so low (3.75%), I’m thinking I can do better.

In fact I know I can do better. But I don’t want to put the money in stocks.

Two reasons:

1) I want a low beta investment with this “found money”. I’d like flexibility to use it as a future down payment for a second property, or to help lower our mortgage burden once we reach financial independence. I should be able to do much better than 3.75% return in the stock market, but not without too much volatility. In other words, I’m looking for stable returns.

2) We’ve already maxed out our tax-advantaged savings vehicles (401Ks and IRAs). Whatever return this money generates will be taxable. Which means I have to make that much more than 3.75% just to break even.

CA Muni bonds fit the bill. They’re much more stable than the stock market in terms of price volatility, so if I need to use the money, I have a fairly high degree of confidence it will more or less all be there. It’s at least an equivalent risk profile to investing into the house’s equity. If anything is correlated to California real estate it’s CA muni bonds.

Plus it represents another tax-advantaged savings vehicle. I can buy CA muni funds in my taxable brokerage all day long, and not have to worry about income tax implications.

There are a number of CA Municipal Bond CEFs that all pay well in excess of 3.75%. By investing this excess capital in CA Muni funds my tax equivalent yield is much more attractive than the interest rate on the loan, and the risk profile of the investment is roughly similar to the equity in my house, which is what I would otherwise be investing in.

So that’s how I started looking into CA Muni Bond Funds. What did I find?

Welcome to part 4 of 3 in the fixed income fund watch list series:

CA Municipal Bond CEFs

I kind of arbitrarily set my yield limit at 5%. Thanks to the tax-advantaged nature of this investment, anything over a 3.75% yield is hypothetically “beating” the alternative of paying down mortgage principal. I guess I want this to handily beat the alternative.

Back at the CEFA fund selector I filtered for funds that have a 1.5% expense ratio or less. I found a total of 17 funds, all of which are included in the watch list back home. I might consider expanding that out to 2% at some point in the future. Leveraged CEFs can end up spending quite a bit on margin costs. If they’re producing, the extra cost can certainly be worth it.

I only found six funds with a 5% or greater yield.

Three of those were PIMCO funds (PCQ, PCK, PZC) but they currently trade at outrageous premiums to Net Asset Value (NAV)…(10%+). Their average debt quality is below investment grade (BB+), with duration (adjusted for leverage) over 10 years. In other words, they should probably pay 6% or better, but they don’t because of the premium to NAV.

Don’t chase yield children.

Of the three that yielded over 5% AND were trading anywhere close to their NAV, only one was available on my CapitalOne Investing “sharebuilder plan”. The sharebuilder plan allows you to invest a given dollar amount on a regular basis automatically. The trading fees are nearly half ($3.95 vs $6.95), but the downside is you don’t have control over when you make your investments or at what purchase price (no limit orders).

I want to use this investment mechanism because it is the same as making a regular monthly extra payment on the mortgage. And since the amount I’ll be investing each month is so low, the smaller fee is closer to my target of 0.5% ($3.95 / $730 = 0.54%) .

So that’s how I wound up deciding to buy:

Nuveen California Dividend Advantage (NAC)

I made my first automatic investment on Tuesday 7/26. I bought 206.5194 shares for $3,485 including fees. This was obviously more than the $730/month I’ve saved as a result of refinancing. That amount was the payout from the escrow account of the previous month, plus I didn’t owe anything on the new loan in July.

NAC is more or less trading at NAV, although in the week or two since I looked into it, the premium has drifted up to over 1%. I do not want to pay much over NAV. I will keep an eye on the premium and possibly shift gears if it gets too far out of line.

Alternates include:

BlackRock Muni Yield CA (MYC) and BlackRock Muni Yield CA Quality (MCA)

Both are yielding slightly below 5% at the moment, but the effective duration is much less and they’re also eligible for automatic investing.

Invesco CA Value Muni Income (VCV)

Longer duration than NAC, but actually trading at a discount (barely) at the time of writing. Also less than 5% yield. Not too interested in longer duration, same credit quality with lower yield. But if things get super pricey, it’s probably a fine fund if bought at a discount to NAV.

BlackRock MuniHoldings CA (MUC)

The trade off for a slightly lower yield seems worth it considering the significantly lower effective duration and better average credit quality. Plus it’s actually trading at a slight discount to NAV at the moment. The downside is it isn’t available for auto-investing. I probably should have bought MUC with the big chunk of change I had available. Oh well.

5% Honorable mention category include NKX and NZH, although their premium to NAV is pretty spendy, with equivalent duration and credit quality to NAC.

I’m hoping the Fed raises interest rates in September. Not only should it make for super fun times in the stock market, but it will hopefully knock down some of the bond prices?  

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