The purpose of this article is to evaluate the RiverNorth Managed Duration Municipal Income Fund (RMM) as an investment option at its current market price. As my readers are aware, I continue to push muni bond exposure for the new year. However, I am well aware of the risks facing the sector, as well as the broader market. Therefore, I believe selective buying is the name of the game. Specifically, this means finding muni funds that offer relative value, investment grade debt (rather than high yield), and a sustainable income stream. On the surface, RMM appears to check these boxes, with a 6% yield and a 10% discount to NAV. That yield has been maintained throughout 2020, and its holdings are investment grade quality. These are all positive factors.
However, there are reasons for caution as well. Despite having a bullish take on munis as a whole, RMM has some red flags that make me reluctant to use this fund to gain muni exposure. The distribution and yield seem attractive on the surface, but investors need to be aware that roughly half the payout is currently return of capital. This means 2021 will likely see a distribution cut, or a continual deterioration of fund assets to pay for the high income stream. Further, the fund’s expenses are extremely high, especially compared to other options. This too will erode the value of the underlying assets over time.
First, a little about RMM. The fund’s stated objective is “to provide current income exempt from regular U.S. federal income taxes with a secondary objective of total return.” It is currently trading at $17.42/share and yields 6.32% annually. This is a fund that is always on my radar, as it consistently ranks at the top of muni CEFs in terms of yield. Despite that attractive quality, the fund has had a rough 2020. It has dropped by about 10% since the year started, which means it will end up having a negative total return around 4% for the calendar year (after considering distributions), as shown below:
Source: Seeking Alpha
Given this lackluster performance, I wanted to take a deeper look at RMM to see if I should recommend it for 2021. After review, while I continue to be bullish on munis as a whole, I do not believe this is the right way to play the sector. There are a couple of glaring red flags that tell me it is unlikely to out-perform other CEFs in the space, and I will explain why in detail below.
Why Consider RMM – One Of The Highest Yields
To begin, I am going to shoot off a couple of quick points on why RMM looks attractive, hence the reason for this review. The first has to do with current yield. Back at the start of the year, RMM caught my eye because it was the only muni CEF with a 5% yield. That looked attractive, but it clearly was not enough to protect it from the sell-off we saw in Q1. While the fund has rebounded since hitting a low in March, it has not recovered the way other muni CEFs have. As a result, despite the distribution being the same absolute amount now as it was at the beginning of the year, the current yield has risen to over 6%. This reality continues to make it one of the highest yielding muni CEFs out there today, as shown in the graphic below:
Source: CEF Connect
The takeaway here is a simple one. For those most concerned with yield, RMM probably catches the eye. It is difficult to find an investment grade muni CEF in the 6% range, but RMM offers it. I will explain later in this review why I am not impressed with this yield after digging a little deeper. But on the surface it is attractive and will continue to pique investor interest going forward.
Why Consider RMM – Large Discount To NAV
Aside from the current yield, there is another attribute that, on the surface, makes RMM seem like a great candidate. Specifically, this is the fund’s valuation, which hit a discount to NAV above 10% after the close on Friday:
There are a couple of reasons to like this metric. One, it clearly offers investors quite a bit of value, which is no easy challenge to find in today’s environment. Buying into investment grade bonds for 10% less than they are worth is often a smart play, especially for the most risk-averse investor. In isolation, this metric suggests there is opportunity here and, in relative terms, the story is also positive. While a 10% discount is higher than what most muni CEFs offer right now, when we look at RMM’s direct competitors from the same asset manager, RMM also wins out. It has a wider discount than its two sister funds from RiverNorth, which are the RiverNorth Opportunistic Municipal Income Fund (RMI) and the RiverNorth Flexible Municipal Income Fund (RFM). The current discounts for these two CEFs, respectively, are shown below:
My point here is, again, RMM seems to be a valid buy candidate on the surface. The discount is wide, and it is more attractively priced than its direct competitors. While I have already noted I am not bullish on this fund, I think it is important to recognize the positives behind the current valuation. This is a key reason why I am not “bearish” on the fund, and rather have a more neutral view. I see little chance of out-performance for RMM, but the 10% discount should also help limit the downside potential going forward.
Corporate Muni Buying Has Been On The Rise
My next point will take a look at the broader muni market, to help explain why I remain bullish on this asset class. Clearly, this has been a challenging year for most market sectors, and that includes munis. With tax revenues falling, jobless claims elevated, and a lack of meaningful support from Congress to state and local governments, munis are under pressure. Therefore, it is reasonable for investors to view this thesis with caution.
However, there are a few key reasons I believe we will see limited defaults next year. One, munis historically have a very strong track record, with lower default rates than corporate bonds. Importantly, this is a trend that has been consistent for decades, as shown below:
Source: T. Rowe Price
Two, with President-elect Biden coming into the White House next year, I believe there will be greater pressure on Congress to provide direct aid to the states. This is my personal opinion, and stems from the fact that some of the worst-hit states during this crisis are firmly in Democratic control. States such as New York, New Jersey, Illinois, and California have all been epicenters of the pandemic, due to their large, densely-populated cities. I expect their requests for more aid will be more warmly received by a Democratic presidential administration.
Three, even if that does not happen, the Fed has opened up a liquidity line for municipalities, which so far has not been tapped much. In fact, there have only been two transactions so far (as of November 15th), which shows the liquidity line has been greatly underutilized. In fact, total transaction volume amounts to less than 1% of the available liquidity, as shown below:
These two transactions were for the state of Illinois and the MTA in New York, neither of whom have accessed the credit line a second time. This means there is plenty of liquidity left for state and local governments to draw on should the need arise.
While these predictions may seem as too optimistic for some, consider that there is building demand for munis in the corporate sector. This helps support the idea that institutional investors also see the value in munis right now, which tells me that retail buyers will be in good company. This is an important point because large companies, typically banks and insurance companies, used to buy up a healthy percentage of munis bonds. Post-tax reform, this dynamic changed a bit, since the tax-savings from the bonds became less attractive as domestic tax rates declined. With corporate tax rates unlikely to go lower in 2021, and perhaps even to go higher, large institutions have begun to increase their buying of munis again. To illustrate, consider the current muni holdings of commercial banks, which have been rising in every consecutive quarter since Q2 2019, as shown below:
My takeaway here is quite positive. Institutional buying gives me a lot of confidence on the surface. Further, the buying has been consistently rising over the last year and a half, which should prove to be a key source of demand going into the new year. This means even if retail investors hold back a bit due to the macro-picture, corporate buying could make up the difference. Finally, as I highlighted in the graphic, bank holdings of munis are still below their Q4 2017 levels (which was the last quarter before the tax reform changes went into effect in 2018). This means the current level of holdings is still below its historical pre-tax levels. My takeaway is that this means there is plenty of room left for banks to keep buying munis, providing a tailwind of future demand that retail investors who buy now can benefit from.
Munis Are A Very Relevant Equity Hedge
Expanding on why I like munis in the new year, I must reiterate my outlook on equities. Overall, I expect stocks to have a reasonably positive 2021, which is not a controversial assumption since U.S. stocks typically rise in a given calendar year. However, we enter the year at historically high levels, suggesting to me a short-term pullback could be in the cards. As a result, I am adding to my current stock positions only modestly, and building up my equity hedges while I wait for a potential pullback. In this vein, it should be fairly obvious why I like munis, as the sector has one of the lowest correlations to the S&P 500 in the fixed-income world, as illustrated below:
Source: RBC Wealth Management
The takeaway here should be that munis offer a reasonable alternative for investors worried about stock prices, as I am. While other sectors, such as high yield corporates and preferred stocks, may offer a higher income stream, they also have a higher correlation to stocks. This makes them less relevant as a hedge, and supports my view that munis are a smart option at the moment.
So What’s The Problem? Fees and Return Of Capital
This review thus far has had a fairly positive slant. First, I noted a couple of potentially positive attributes for RMM. Second, I laid out my case for why I like munis, which RMM holds exclusively. Yet, I noted at the beginning I have a neutral rating on this CEF, and would not recommend it as a way to play the muni sector. Therefore, readers are surely asking, what is the problem?
The answer to this question is two-fold, and quite simple. Specifically, there are a couple very important attributes from RMM that set it apart from the average muni CEF, in a negative way. These two points alone make me reluctant to recommend RMM, and suggest this is not an appropriate vehicle as a long-term hold.
The first has to do with expenses. The actual expense ratio is buried in RMM’s disclosures and it is also a bit misleading since RMM is a “fund of funds” CEF. This means investors are paying for the asset managers of RMM directly, but also for the underlying management fees of the CEFs it owns within its portfolio. This greatly increases what investors are paying to own the underlying bonds, and is really only worth it if we see superior performance. Given the fund’s 2020 return, coupled with its return since inception, superior performance is clearly not what investors are receiving.
Now, we could take a deep look into RMM’s expense ratio and where the money goes and how this compares to other CEFs. However, I have a better way to illustrate just how expensive this fund is without digging too deep. In a very straightforward way, we will clearly see the expenses for this fund are astronomical. To illustrate, according to the most recent annual report for RMM, which came out in June, the fund’s total expenses were roughly two-thirds total investment income, as seen below:
Quite frankly, I don’t need to say much more, this graphic is worth a thousand words. The total expenses are incredibly high considering the income the fund is bringing in, and clearly demonstrates why this fund sits with a discount to NAV. Simply, investors are likely concerned about the underlying cost to own this fund. A discount is nice, yes, but expenses will eat away at a return just like buying at a premium price will. Until the expenses for this fund come down to a reasonable level, it will remain on my avoid list.
Distribution Is Majority Return Of Capital
My final point looks at RMM’s distribution more critically. I noted earlier the yield seemed impressive at over 6%, but came with a caveat. This caveat is that the distribution is not nearly as attractive as it seems, since the fund is paying out a large portion of it as return of capital (ROC). What this means is, RMM is not really doing anything special to offer a higher current yield than the general muni CEF universe. The fund owns the same types of bonds as other muni CEFs, and owns a few attractively priced muni CEFs as underlying holdings also. Yet, management does not have any magic beans, so to speak, and is not generating a higher income stream through skill like one might expect. Rather, it is paying out a larger distribution than it could if it had to rely on investment income. In fact, just under 52% of the most recent distribution was ROC, as shown below:
This is concerning, and tells me a couple of important things about this fund. One, the 6% yield is not “tax-free.” The distribution being offered is coming from ROC, which is not necessarily tax-exempt income. The fund managers could be generating some of this capital through an alpha-generating strategy of trading the underlying bonds/CEFs at attractive buy and sell points. However, this benefit is partially negated by the fact that investors will need to pay income taxes on this part of the distribution. Avoiding income taxes is a primary reason for investing in munis in the first place. Further, this tells us the effective yield of RMM is not much better than buying a muni CEF with a tax-exempt income stream in the 4-5% range. Munis often register a better after-tax yield than other fixed-income securities, making the stated yield not the primary consideration. This appears to be the case with RMM – the yield is higher, but the real yield may very well be lower for investors in higher tax brackets that have to pay taxes on the portion of the distribution that is ROC.
Importantly, this last month was not a fluke. If we look at the two prior distributions, a similar pattern emerges. October’s notice was similar to November’s, while September’s notice showed an even worse disparity, as shown below, respectively:
The point here is that the 6% yield is not impressive to me because one of two things will happen next year. One, the fund managers will need to cut the distribution rate to get it more in line with actual income earned. This means the yield, while higher than my holdings now, may very well not be higher next year. Two, in absence of an income cut, the distribution will continue to have a high percentage of ROC. This means the tax-exempt portion on the yield will be minimized. This makes the yield less of a relative value compared to my current muni holdings. While my investments may yield less before taxes, they are probably going to have a superior income stream after taxes.
With a new year comes a fresh outlook on RMM. Despite finding value in the muni bond sector, I recommend investors buy individual bonds and funds very selectively given the challenging climate. As a result, RMM is on my avoid list. In fairness, the high yield and 10% discount should help the fund generate a positive return. However, I expect it to lag other muni CEF offerings because of its high level of expenses and distribution that has a significant amount of ROC. These factors all combine to support a neutral view. Therefore, I would suggest investors approach RMM very cautiously in 2021.
Disclosure: I am/we are long NEA, MUS, BBN. 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.