New River Investments LLC Tax-Exempt Bonds and Tax-Exempt Bond Closed-End Fund Report July 2013

Guillermo Roditi Dominguez, Managing Director Alberto Roditi, Managing Director

Introduction In order to keep this letter brief, we will restrict the focus of the following commentary to one asset class, in this instance tax-exempt bond CEFs and their underlying bonds. We chose this topic for this communication because it is the latest large addition to our portfolio and, as such, the data is recent and analysis timely. It is our hope that this will give you a real-time insight into the methods we use to decide how we allocate capital. Our inclusion of this analysis is not to sell you on our thesis, it is to expose our methods and allow our partners to transparently see the process that has gotten us here and why we’ve chosen to make the investments we made. When possible, we’ve tried to use simple terms, but the technical nature of the content means some requirement of basic statistics may be necessary to make sense of much of the commentary.

Are Tax-Exempt Bonds Expensive? This is a tough question to answer because there really is no such thing as a monolithic “muni bond” complex. Bonds are split amongst at least 4 major categories, tens of tenors, and at least 4 major rating brackets (we eschew analysis of the speculative-grade market as this market is primarily composed of conduit deals, not municipals). Because of the hundreds of permutations observable, it is important to pick a benchmark. We use the Bloomberg Fair-Value AAA US Municipal General Obligation Option-Free curve. There are many different gauges of value for municipal bonds, the most common being the ratio to measure. The traditional narrative is that due to their tax-exempt nature, bonds should trade at a yield that makes their taxable-equivalent yield equivalent to similar taxable bonds and so, if one were to hold tax-rates constant, AAA bonds (credit-risk free) should trade at a fairly constant ratio to treasuries. However, the empirical reality is that ratios appear to be a function of interest rates, as can be seen in Figure 1. This can make ratios look more attractive than they really are when rates are low. To correct for this factor, as well as to incorporate additional relative value factors, we use a multiple-regression based model. You can read a more detailed account of how the model is constructed at http://blog.morallybankrupt.org/2013/07/muni-madness-redux.html.

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Our model indicates that as-of July 31st, the BFV 10yr bond yielded 0.40% more than our expected yield, or about 2.2 standard-deviations. Figure 3 illustrates a long-term time series of our predicted AAA yield and the observed yield. Figure 4 represents the difference between the expected and observed yields. A positive number indicates that yields are higher than we expect them to be and a negative number that yields are lower than we expect them to be. The distribution exhibits a strong central tendency and a small number of large outlier events. In the past 21 years, we have only observed 52 observations where the difference between expected yields and actual yields was higher than July 31st, 3 of which were recorded in July. We interpret this result as an indication that 10y GO AAA tax-exempt bonds are cheap relative to other taxable credit risk-free counterparts. Figure 2 illustrates the cumulative density of observations for the difference between observed and expected values, with the red line marking the value as-of July 31st. It is important to stress here that this does not mean yields cannot increase; only that, if the model holds, these bonds are cheaper than their peers. This same exercise can be repeated for different tenors and other benchmark curves.

We continue this analysis by extending this measure to the spread commanded by lower credit ratings. Although the data points across time are not directly comparable due to changes in how securities are rated by the rating agencies, the data still gives us a view into how much extra income lower-rated investment-grade securities provide. This is illustrated in Figure 5. As-of July 31st, the AA- index had a yield that exceeded the already wide AAA index by 0.13% and the spread between AA- and A- indices was 0.71%. In other areas of the curve, these premiums are even higher, as illustrated in Figure 7.

We will omit here the tireless iterations for every permutation of tenor, credit rating and bond category, but our methods do not signal to us that the tax-exempts bonds we are examining are at a high risk of underperformance. While A to BBB spreads look a little low, AA to A spreads are high, meaning that BBB yields are not uncommonly expensive. By our analysis, lower-rated bonds are selectively cheap in some places and fair value in others, while the curve benchmarks remain decidedly cheap. For example a 10y A- General Obligation bond would be expected to yield 3.84% which, at a 30% tax-rate, would be 5.485%. For comparison, the iBoxx High Yield corporate Bond ETF as an average Yield to Maturity of 5.82%, only 0.33% higher, and carries investments that are at high risk of substantial credit losses. We therefore conclude that investment-grade tax-exempt bonds are comparatively cheap. For more information on credit loss estimates, you can request our previous commentary or find a slightly redacted version online at The Contrarian Corner: The Low Return of High Yield http://thecontrariancorner.com/?p=9740

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Should We Own Bonds? We have concluded that tax-exempt bonds are not overvalued and that, compared to corporate

high-yield bonds, they are comparatively cheap as we can achieve similar tax-equivalent yields while taking much lower risk of permanent capital losses. However, we have not established whether owning any bonds at all is a desirable outcome. For this part of the analysis we once again refer to the right column of Figure 7, the rate changes required over a 12-month period to achieve a 0% total return. The recent shocks to interest rates may seem to make these changes seem quite plausible, but it is important to remember the Fed Funds rate is likely to remain fixed at 0.25% for the foreseeable future. Although the FOMC’s discussion of slowing or ending its Large Scale Asset Purchase (LSAP) program have induced a collective fear of a rapid pace of tightening and rate increases, leading to a steeper slope on the yield curve, we have not seen evidence that we are close to rate increases. We would also like to stress here that, in credit-insensitive assets (assets where the risk of substantial permanent loss of capital from credit losses is small) a higher discount rate (price declines) directly translate to increased expected returns by definition. An environment in which discount rates increase and prices decline is an environment in which marginal cashflow can be reinvested at higher expected returns.

To judge the risk of rate increases it is important to remember how monetary policy works. At the present time, the Fed primarily relying on two tools to handle monetary policy: rate policy and quantitative policy. It uses these two tools to achieve its mandate of price stability (currently defined as a 2% symmetrical inflation target as measured by the core personal consumption expenditures deflator) and full employment. At the time of this writing, rate volatility appears to have been triggered by discussions of pulling back on quantitative stimulus. That is reducing the rate at which the Fed is easing, not tightening. Our focus for the purpose of this exercise, however, is rate policy. Rate policy is primarily used as a tool to disincentivise borrowing by making it more expensive. Assuming a negatively sloped demand curve, a higher cost of borrowing will reduce the quantity of borrowing demanded and constrain the banking system’s function of money multiplication by limiting velocity. Ultimately, this leads to less credit-driven

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Consumption and/or Investment, which puts downward pressure on inflation. Therefore, in order for rate increases to be necessary, inflation must exceed the symmetrical target of 2% during a period of close-to or full employment. In contrast to prior cycles, the Fed has “guided” market participants as to the meaning of these measures by disclosing what is colloquially referred to as the “Evans Rule,” a threshold (not a trigger) which suggests unemployment to fall below 6.5% and the 2% symmetrical target to be met or breached before increases to the target FF rates are increased. Given that core PCE inflation is significantly below its symmetrical target of 2% (Figure 7), unemployment remains elevated and employment growth tepid, and annualized nominal GDP growth has averaged less than 3% 2 consecutive quarters and has been decelerating for 5 quarters, we believe the risk of rapid rate increases in the near future is very low. There is simply not enough loan demand to fuel a robust expansion, and certainly not enough to warrant the use of monetary policy to disincentivize already low and declining loan demand. As such, we believe that, although short-term price volatility has been unpleasant, the risk of rates increasing fast enough to significantly lower the total return over a 12-month period to a level lower than their current yield (a detailed explanation of this under “About the roll”) is low enough to make the term premium (the positive slope of the yield curve) an attractive risk premium to take.

About the Roll When the yield curve is positively sloped, if it remains positively sloped, there is two potential sources of return for a bond. The first is carry, the coupons paid out, and the second is “roll-down.” Roll-down represents a change in the bond price caused by the discount rate diminishing as maturity shortens. For example, if you bought a AAA GO 10y par bond on July 31st at 3% and held it for a year while rates remained totally unchanged, you would have a 9y bond, which is discounted at the lower rate of 2.71% and therefore the price of the bond would be higher. Because of this, a steep curve is the best protection against higher interest rates. In the example used above, 9-year rates would have to increase by more than 0.29% over the course of the year for the total return of the bond to be less than the yield at which it was purchased.

Currently, the term structure, particularly maturities less than or equal to 15 years, feature a particularly steep slope. This steepness creates ample protection against increasing rate scenarios and means that a portfolio of bonds can generate positive total returns even as interest rates increase. Figure 9 illustrates this point in more detail.

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About Tax-Exempt Bond Interest Rate Sensitivities In the section titled “Are tax-exempt bonds expensive?” we briefly discussed tax-exempt bond yield ratios and the relationship between treasury yields and tax-exempt yields. A more technical review of their relationship can be seen in Figure 8, which illustrates the highly linear relationship between tax-exempt bond yields and US Treasury yields. As the coefficient of the simple (yet highly explanatory) linear regression highlights, every 1% increase in US Treasury rates translates to roughly 0.60% of rate increase in the AAA tax-exempt yield. Continuing our precious example from “About the roll,” 9y rates would have to increase by 0.29% over a year for total return to be less than current yield, which would translate to a 0.48% change in the treasury curve. A total return of zero would require a 1.13% move in treasury rates, all this without pricing in a contraction of the 0.40% in excess spread already priced-in to the bonds (Figures 3 & 4 and “Are tax-exempt bonds expensive?).

A Snapshot of the Investment Grade Tax-Exempt market Figure 9 illustrates, on the left, the yield curves as-of July 31st for three subsections of the

municipal bond market. The charts on the right represent the yield change that would be required for a security to achieve a total return of 0% over a period of 1 year. E.g. if you bought a Muni GO AAA 10y bond (top, blue), 9y yields would have to rise by 0.68% in order to leave your total return at zero.

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Closed-End Funds As we feel we have sufficiently documented how we came to the conclusion that investment-grade tax-exempt bonds are unlikely to provide unattractive risk-adjusted returns, we will now continue with the particular vehicle selected to make this investment, closed-end funds (CEFs). In contrast to their open-ended cousins, CEFs trade at a price independent of their net asset value. On certain occasions, the market price declines a more than the value of their underlying assets (NAV), creating the opportunity to buy a fund which represents a large pool of bonds at a price which is less than the value of its underlying assets. These discounts have proven to be highly mean-reverting over their lifetimes, undergoing quick and sharp increases followed by almost equally sharp reversals. Figure 10 shows the weighted-average discount of all the 92 largest and most liquid funds (the ones we consider investable) in blue. The colored area represents the range of observations in that weighted average and the light brown line measures the statistical skew of observations.

As of July 31st, our screen tracked the largest and most liquid 92 funds representing a combined $36.7 billion in assets with a weighted average discount of 6.9%., with the cheapest funds trading at discounts of over 12%. Of the last 1000 trading days, only two days have featured higher discounts. This suggests there is an attractive opportunity to buy assets below their fair price. In a declining asset price scenario in which the discounts revert to their historical mean, this would give provide downside protection, under a stable or rising asset price scenario, it would allow for capture of a shrinking discount through increases in the fund’s price. Figure 11 represents a similar chart using monthly periodicity to fit a period that goes back to 1994. Including the global financial crisis, there is only 19 months since 1994 when the weighted average price as a % of NAV has been lower, 6 of which occurred during the global financial crisis, under financial distress we are unlikely to repeat in the near future and under conditions that were remarkably different than today’s.

Although CEFs represent an imperfect proxy for investment-grade tax-exempt bonds due to a mix of credit that may include some non-investment-grade bonds, individual security selection allows investors to select funds with a high concentration of holdings in investment-grade funds, which constitutes our entire sample.

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Why do fund prices vary so much? There is no clear explanation to the major discount cycles, which tend to last about 4 years from trough to peak and 12-18 months from peak to trough. As-of July 31st, 10 full months had elapsed since the latest peak in the cycle with the weighted average discount for the observed universe increasing by 10.24% in that time period, roughly the same as the average peak-to-trough for the five observed cycles in Table 1. Although the current value suggests that there may still be more downside to the area of 90%, many funds are already retesting previous cycle lows. Figure 12 showcases one such fund.

Table 1

Peak Period Trough Period Peak Value Trough Value Total Decline Length Aug-93 Dec-94 102.10% 90.00% -12.10% 16 Dec-98 Dec-99 102.25% 89.15% -13.10% 12 Jun-03 Apr-04 97.50% 91.30% -6.20% 10 Apr-07 Nov-08 99.23% 87.65% -11.58% 18 Sep-12 Jul-13 103.34% 93.10% -10.24% 10

Average 100.58% 90.30% -10.28% 12.50

The Liquidity Premium Although it is easy to become fixated on further downsize, it is important here to highlight that

the complement of liquidity risk is opportunity risk. The unwillingness to risk a 3% decline may end-up costing an investor an attractive entry to a cheap asset. The desire to “time” the market must be balanced by a careful analysis of potential short-term downside. We refer to the expected return for holding an asset that may have further downside as the liquidity premium. To calculate the liquidity premium we calculate the expected return from discount normalization and amortize it through the length of time expected to elapse before normalization. Given a 46 month average between trough and peak cycles, we use a 24 month expected time to normalization. We elect this period because, by definition, the median of the sample must be observed during the first half of the sample. This is not a random estimate, but mathematical reality. That isn’t to say that previous medians must be realized, but we feel strongly about the likelihood that they will based on the distribution of events over the last twenty years. The observed universe sample has a median average discount of 4.3% (95.7% as a % of NAV); therefore the expected return from normalization would be 2.6% or 1.3% annualized of additional return. In addition to that, the increase in yield for the weighted average assets would be an additional 0.176% based on a weighted-average yield of 6.956%. If the sample is restricted exclude the most expensive quartile (as measured by discount standard deviations from median) the expected return from normalization rises to 5.1% and the yield increase to 0.336% based on a weighted average yield of 6.8%.

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Events like this indicate collective negative extreme in sentiment towards a group of assets and they represent an opportunity for those investors able to invest using longer time horizons to capture an additional risk premium and increase their returns. If the universe is furthermore restricted to only the most attractive quartile, the expected return from normalization rises to 7.2% and the increase in yield to 0.455% based on a 6.756% weighted- average yield. One interesting pattern here is that the most attractive funds feature lower weighted-average yields. Because once adjusted for expenses and leverage, a higher yield has to be indicative of higher credit risk or longer maturities; this difference suggests that current investors are—irrationally, in our opinion—pricing these assets based primarily on their distribution and not the underlying value of their assets. This behavior is precisely what we seek to identify and exploit as active managers as we attempt to purchase assets with higher expected-returns and lower risk than a passively-managed market portfolio.

Conclusion It is our opinion that, currently, investment-grade tax-exempt municipal bonds offer the potential for attractive risk-adjusted after-tax returns and investing in highly diversified pools of such funds through closed-end funds carries the opportunity to earn an additional risk premium (the liquidity premium) for investors with longer time horizons based on our analysis of historical data. As always, we welcome any comments and questions you may have regarding our analysis.

Sincerely,

Guillermo Roditi Dominguez, Managing Director, guillermo@newriverinvestments.com

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