(10/12/11) The Top High-Yield Muni Bond Fund

A year ago, many analysts were predicting a municipal bond meltdown, but that has hardly been the case, writes Steven Pikelny of Morningstar.com.

Pioneer Municipal High Income (MHI) is a high-yield municipal closed-end fund, or CEF, that generates most of its income through speculative-grade and nonrated municipal bonds. The fund has had above-average performance since inception in July 2003, and has been able to provide high distributions with lower-than-average leverage.

Because high-yield municipal bonds are considered riskier than investment-grade munis, this fund is not suitable for all investors. However, for those looking to access the illiquid high-yield municipal-bond market, this fund may fit the bill.

MHI’s investment objective is to generate high levels of tax-exempt income. It accomplishes this by investing at least 40% of its assets in speculative-grade and nonrated munis from various states. These junk bonds typically pay higher yields than investment-grade bonds as compensation for increased credit risk.

The fund determines its sector, state, and maturity weightings by conducting top-down macroeconomic analysis, followed by bottom-up fundamental research in an attempt to discover undervalued securities. Managers favor revenue bonds to general-obligation bonds due to their steady revenue streams.

As of July 31, about half of the fund’s 134 holdings were non-investment-grade or unrated. The portfolio’s average weighted credit quality was BB+, about average for its peer group (Morningstar determines average credit quality by placing more weight on lower-rated bonds).

Currently, the fund has large exposure to health care and transportation (33% and 16.5% of the portfolio, respectively).

Its emphasis on revenue bonds is exemplified in its 1.22% allocation to a bond from Central Falls, Rhode Island, which is tied to the revenues of a detention faculty. Although pension obligations pushed this small city into default in August of this year, the detention center is still able to make its promised payments, as its revenues were unaffected.

About 60% of holdings mature in more than ten years. This, along with its lower-rated holdings, pushes the fund’s leverage-adjusted duration (a measure of interest-rate sensitivity) to 12.6 years, which is on par with the peer average.

MHI is one of the least leveraged high-yield muni CEFs, with a leverage ratio of 1.33 (total assets/net assets), which is well below the peer average of 1.56. The fund’s leverage is composed entirely of auction-rate preferred shares, which during the last full fiscal year had an interest rate of 0.4%.

This fund, which carries a Morningstar Rating of three stars, has outperformed both the Morningstar US High Yield Municipal Leveraged peer group and the Bank of America Municipals BBB Rated Index over one-, three-, and five-year periods.

In the past year, the fund has matched peer performance with a gain of 5%. For the latest three- and five-year annualized periods, the fund has beaten peers: It’s up 11% and 5%, while the peer group is up 8% and 3%.

Although the fund was hit hard during the 2008 financial crisis, losing 27% of its net asset value, it rebounded strongly in 2009 with a 43% gain, compared with a 36% loss and 52% gain for other high-yield muni CEFs.

The fund compares even better with the Bank of America Municipal BBB Rated Index, which is up 3% in the past year and nearly 6% and 4.5% during the past three and five years.

Prior to the 2009 recovery, the fund traded at a persistent discount. However, an increased interest in municipal bonds, coupled with a 20% increase in the fund’s distribution over the past two years, pushed its discount to a 3% premium. The three-year average discount is 1.3%, while the six-month average premium is almost 3%.

The fund’s 8% distribution (at NAV) is on par with the peer average. Because the fund has a lower-than-average leverage ratio, its distribution rate adjusted for leverage is 6.2% and is among the highest in the peer group.

Moreover, the income-only distribution has steadily increased from 6.4 cents to 9.5 cents per share in the past five years. Investors should note that 12% of income distributed is subject to the Alternative Minimum Tax. Those not subject to the tax, however, need not worry.

We believe that, although the fund has below-average leverage and an average credit rating, its above-average performance is likely made possible through its extensive positions in nonrated bonds. The average-credit-quality metric gives equal weight to these securities regardless of their credit quality, though the market prices them accordingly. This implies that the fund is either taking on more risk through higher-yield holdings, or is effectively utilizing its research capabilities to identify undervalued securities.

David Eurkus, with the help of Timothy Pynchon, has managed this fund since inception. Eurkus and Pynchon also manage sister fund Pioneer Municipal High Income Advantage (MAV), which has a higher distribution rate with similar total-return performance.

Both managers have extensive investment-management experience: Eurkus has been managing funds for 26 years, and Pynchon for 11 years, but we are disappointed that neither manager owns a significant stake in MHI. Pynchon owns less than $50,000 in shares, while Eurkus owns none. Eurkus and Pynchon also co-manage two open-end municipal-bond funds.

The fund’s parent, Pioneer Investments, manages close to $250 billion in assets across a wide range of investment vehicles, five of which are high-yield fixed-income CEFs.

Because of its junk muni holdings, the fund faces greater credit risk relative to investment-grade muni funds. However, because bonds are assigned ratings based on their asset class, this fund does not entail the same risk as a fund holding high-yield corporate bonds.

Moreover, some of the credit risk is mitigated through the diversified portfolio, 10% of which is insured.

Though default risk remains relatively low, the fund’s historical returns have been volatile. Its three-year standard deviation is 14.55, which is on par with peers. However, this is nearly 3 times the standard deviation of the Barclay’s Capital Municipal Index, which represents investment-grade municipal bonds. The fund’s duration is high on an absolute basis, but is on par with peers.

Many municipal CEFs are thinly traded, and investors should be aware of this when placing orders to buy or sell shares. The fund’s average daily trading volume over the past three months is a miniscule 50,000 shares. When placing orders to buy and sell shares of any CEF, we recommend using limit orders.