BKN: Strong Municipal Bond Fund, 4

BKN: Strong Municipal Bond Fund, 4.9% Yield, Investment Grade Holdings, Market-Beating Performance

The Investment Quality Municipal Trust (BKN) is a leveraged bond CEF focusing on tax-exempt investment grade long-term municipal bonds.

BKN is a higher risk higher reward investment opportunity when compared to municipal bond index ETFs, or to bond index ETFs more generally, with stronger long-term performance but greater losses during downturns. At the same time, the fund performs moderately better than its CEF peers on both risk and reward metrics, a solid combination.

BKN is a strong investment opportunity, and particularly appropriate for investors looking for tax-exempt municipal bond funds, but desiring greater distributions and returns than those of an index fund.

As a final point, as I originally wrote this article close to a month ago, I decided to see how BKN has performed since. The fund continues to outperform bond and municipal bond indexes, as it has in prior years.

Fund Basics

  • Sponsor: BlackRock
  • Dividend Yield: 4.92%
  • Expense Ratio: 2.53%
  • Discount to Nav: 4.0%
  • Total NAV Returns CAGR 10Y: 8.02%

Fund Overview

BKN is a leveraged municipal bond CEF administered by BlackRock, one of the largest investment managers in the world.

The fund itself focuses on tax-exempt municipal bonds, and these compromise at least 80% of the fund’s total holdings. Consider the tax benefits and implications of this before making a final investment decision. The Taxable Municipal Bond Trust (BBN) is a similar BlackRock fund focusing on taxable municipal bonds, and might be more appropriate for investors looking for these securities.

BKN focuses on higher quality lower risk municipal bonds with strong credit ratings, with investment grade bonds compromising at least 80% of the fund’s total holdings. These are very strong securities, and should lead to very safe, albeit somewhat low, distributions and returns:

(Source: BKN Corporate Website)

BKN’s holdings are reasonably well-diversified across states, which should lower portfolio risk and volatility, and minimize losses in the event a state defaults:

(Source: BKN Corporate Website)

BKN’s holdings are actually quite a bit more diversified than those of the iShares National Muni Bond ETF (MUB), the most common municipal bond benchmark. Diversification is almost always a positive, and should serve to further lower portfolio risk and volatility:

(Source: MUB Corporate Website)

BKN’s holdings are tilted towards higher-maturity bonds, with an effective average duration of 14.05 years:

(Source: BKN Corporate Website)

BKN’s high effective durations means that investors should, in theory, see very sizable losses when interest rates increase. In practice, I have not seen these losses, although municipal bond yields have remained relatively stable throughout the years, minus some short-term gyrations these past few weeks, so the analysis was less thorough than expected.

From late 2017 to mid-2019 municipal bond yields increased by about 0.30%, a reasonably large increase for these securities:

Chart

Data by YCharts

BKN managed to perform reasonably well even as yields increased, although there was some volatility, and performance was quite poor until yields stabilized:

Chart

Data by YCharts

I’ll be taking a closer look at the fund’s performance in a little while, but it seems that BKN has quite a bit of interest rate risk, but has performed reasonably well during past periods of rising interest rates.

BKN seems like an extremely low risk fund, at least so far, but the fund does have quite a few sources of risk, most importantly its use of leverage. Leverage amplifies both gains and losses, and should lead to stronger long-term shareholder returns, with also stronger losses during downturns. If the downturn is severe enough, the fund might be forced deleverage by selling off assets at rock-bottom valuations, decreasing the dividends received by the fund and its shareholders, and preventing the fund from recovering once asset prices stabilize. These losses can be massive. For example, I estimated that most MLP CEFs suffered losses equivalent to 30%-50% of NAV purely due to forced deleveraging, a significant amount, in a previous article.

BKN’s current use of leverage is, in my opinion, excessive, with the fund financing about 41% of its managed assets through debt. Most funds use lower levels of leverage, with 20%-35% being relatively normal. BHK uses 25%, for instance.

(Source: BKN Corporate Website)

The figures above are for April 30th, the absolute bottom for municipal bonds, so it seems almost certain that the fund’s leverage ratio is stronger now. I’m not too concerned about the fund’s leverage, but might become so if these figures don’t materially improve in the coming months.

BKN’s focus on longer-term bonds, use of leverage, and active management, combine to boost the fund’s dividend yield. At 4.92%, BKN’s dividend yield is quite a bit higher than that of MUB, but moderately lower than that of most PIMCO municipal bond funds:

Chart

Data by YCharts

BKN’s dividend is also completely covered by the fund’s underlying generation of income, as per the fund’s latest annual report:

(Source: BKN Annual Report)

Finally, the fund’s average coupon is currently significantly lower than its yield to maturity:

(Source: BKN Corporate Website)

This happens when bonds trade at a discount, and should lead to significant shareholder returns if/when economic and market conditions stabilize. I attempted to estimate these, but it seems that the fund only provides the necessary information in their annual and semi-annual reports, both of which are woefully out of date.

Let’s review. BKN focuses on long-term tax-exempt investment-grade municipal bonds. The fund’s high quality holdings should serve to reduce portfolio risk and volatility while reducing yields and returns, while the fund’s high average duration and maturity should have the opposite effect. Performance is partly dependent on management decisions and capabilities, and could conceivably lead to market-beating returns.

With the above in mind, let’s take a look at BKN’s performance.

Performance Analysis

BKN’s past performance is that of a higher risk higher reward bond fund, but with an attractive risk-return profile. The fund outperforms both municipal bonds and bonds in aggregate during bull markets and in the long-term, such as during the past ten years:

ChartData by YCharts
Data by YCharts

The fund, however, underperforms during downturns, including during the first three months of the year, in which valuations and prices of many/most securities collapsed:

ChartData by YCharts
Data by YCharts

BKN also compares quite favorably to its CEF peers, with the fund outperforming the average municipal bond CEF on both a NAV and price basis across most relevant time periods. BKN has underperformed during the past month, but only because it suffered fewer losses earlier in the year:

(Source: CEFdata)

Finally, I wanted to do a quick comparison between BKN and all relevant PIMCO municipal bond funds. I’ve attempted to exclude funds focusing on just one state, as well as those with target maturity dates, so hopefully the comparisons are informative. These figures are about a month old by now, but I believe that the general point holds, and that they are reasonably material.

BKN performs quite a bit better than the average PIMCO municipal bond fund, and almost always outperforms the average of these on both a price and NAV basis:

(Source: SeekingAlpha – chart by author)

It is interesting to note that BKN’s relative performance is stronger on a price basis, and was particularly outstanding during the past year. This is due to the fact that PIMCO funds tend to trade with very large premiums, while BKN usually trades with a small discounts.

ChartData by YCharts
Premiums reduce distribution yields, directly decreasing shareholder returns, and are particularly harmful during downturns, as premiums tend to narrow during these.

BKN’s discount, on the other hand, is a positive for the fund and its shareholders, although the discount is quite small and has been moderately larger in previous years.

To summarize, BKN is a higher risk higher reward fund when compared to municipal bond and aggregate bond indexes, and performs quite a bit better than its peers.

Conclusion – Strong Tax-Exempt Municipal Bond Fund

BKN’s high-quality holdings, decades-long track record of market-beating performance, and safe, fully covered 4.92% distribution yield combine to create a strong tax-exempt municipal bond fund, and is particularly well-suited for income investors and retirees.

My only concern is the fund’s excessive use of leverage. I do believe that leverage will come down as bond prices recover, which they already have, so I’m not too concerned about this, but other investors or readers might decide to wait for updated figures before making any final investment decisions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seeking Alpha

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