BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio – BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Introduction

Closed-end funds do not seem like the best place to be for active traders, at least on paper. However, these products have been our bread and butter for a while now, and as long as we are capable of detecting opportunities and successfully acting on them, we intend to keep on rolling.

Active followers have taken note of the “Weekly Review” series, and it would only be appropriate to complement these articles with a follow-up, like this one, whose goal is to highlight the funds of interest to us.

Why Municipal Bond Closed-End Funds Deserve Attention?

Source: Getty Images

Municipal bonds are debt obligations issued by public entities that use the loans to fund public projects such as the construction of schools, hospitals, and highways. We find two main reasons to consider municipal bonds:

  • Interest income generally federally tax-exempt: In general, the interest you earn from your tax-exempt municipal securities is exempt from federal income tax and, in some cases, state or local income tax, depending on whether you are a resident of the state that issued the bond. While municipal bonds’ coupons are often lower than those offered by similarly rated corporate bonds, the fact that interest income is tax-free can result in the yields being comparable, or even higher in some cases.
  • Low level of default risk relative to other bond types: While municipal bankruptcies and defaults can and do occur, they have been relatively infrequent when compared to the corporate bond market. Historically, municipal bonds rated by a Nationally Recognized Statistical Rating Organization (NRSRO), and in particular general obligation bonds, have experienced very low default rates.

It may be a difficult task for the individual investor to reach the municipal bond markets, but fortunately, the closed-end funds are a great way to invest in such assets. Municipal bond CEFs are actively managed by qualified managers and have well-chosen and diversified portfolios. They are a perfect choice for conservative investors or just to include an additional “safety” to your portfolio.

A Brief Overview Of The Sector

The benchmark which we use to track the performance of the municipal bonds is the iShares National AMT-Free Muni Bond ETF (MUB). Over the past several months, the main index made a stunning rally and managed to increase its price from $106.42 to $110.02 per share. Respectively, most of the closed-end funds which invest in such kind of assets followed the benchmark and increased their prices. However, I still see an upward potential in some of them and the opportunity to include them to your portfolio.

ChartData by YCharts

Review of BlackRock MuniHoldings Quality Fund II

The potential candidate for your portfolio which I am going to review today is the BlackRock MuniHoldings Quality Fund II (MUE). The price of the fund was under pressure due to the recent dividend cut which was announced. However, the closed-end fund still provides us with relatively high distribution rate compared to its quality peers.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Investment Approach

BlackRock MuniHoldings Quality Fund II, Inc.’s investment objective is to provide shareholders with current income exempt from federal income taxes. The Fund seeks to achieve its investment objective by investing primarily in long-term, investment grade municipal obligations exempt from federal income taxes (except that the interest may be subject to the federal alternative minimum tax). Under normal market conditions, the Fund invests at least 80% of its assets in municipal obligations with remaining maturities of one year or more at the time of investment. The Fund may invest directly in such securities or synthetically through the use of derivatives.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: CEFConnect.com

Valuation

The spread of 8.71% between the price and the net asset value of the fund is at its highest levels for the past decade. Also, compared to the rest of the national munis, the discount of MUE is significantly higher.

ChartData by YCharts

We have plotted the Z-score indicator to show us what is the edge from a statistical point of view. In our case, we have a Z-score equal to 1.00 point. Yes, the statistical indicator is not negative, but it is still one of the lowest ones in the sector.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: CEFdata.com

Current Yield

The current dividend is $0.0490 per common share, and it’s paid on a monthly basis. The current yield on net asset value is 4.38%, and the current yield on price is 4.82%.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: Fund Sponsor Website

Earnings coverage ratio is an important characteristic which most of the investors observe and include in their analysis. It shows whether the earnings of the funds are enough to cover the dividend. In our case, we do have earnings of $0.0485 per share. At this moment, it seems high enough to protect the dividend from an additional decrease.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: CEFdata.com

Relative Analysis

The current yield of the fund is 4.82%, and it may be categorized as an average of the sector. An important note which I would like to make is the situation around the closed-end funds from the sector, which offer higher yields. Most of them are already traded at a really high Z-score, or their latest earnings are not enough high to cover the dividend. So, my purpose is to find good but also safe yield.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: CEFdata.com

Also, the chart below is a comparison of the yield on the net asset value, combined with the discount. From my perspective, MUE is a reasonable combination of these two parameters.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: VIX Central

Portfolio Characteristics

The main part of the investments is with ratings of “AA” and “A” which takes 65.82% of the total portfolio. It is very impressing to find out that 99.18% of the assets are rated as investment-grade quality.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: Fund Sponsor Website

“Prerefund/Escrow” and “Transportation” are the sectors with the biggest weights in the portfolio. From a geography point of view, the fund has 13.70% of its assets from issuers located in California, 12.35% located in Florida and 10.95% in Illinois. The rest of the assets are well diversified between different states.

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: Fund Sponsor Website

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: Fund Sponsor Website

Another important characteristic of the closed-end funds investing in bonds is the duration of the portfolio. The modified duration of the portfolio is 9.33 years.

The effective leverage used by the fund is 37.45%, which is in line with the average effective leverage which is used by the sector.

Hedging Reaction

As usual, we would like to suggest a hedging reaction in case of turbulence in the sector. Here, we have a potential hedging reaction in the face of the BlackRock Muni Intermediate Duration Fund (MUI). Currently, this closed-end fund is traded at 2.80 points Z-score and has a current yield of 3.89%

BlackRock MuniHoldings Quality Fund II: А Quality Municipal Closed-End Fund For Your Portfolio - BlackRock MuniHoldings Qualty Fund II (NYSE:MUE)

Source: Author’s software

Conclusion

Municipal bond closed-end funds seem beaten up, shaken by dividend cuts – which are a healthy necessity most of the time – and full (or perhaps not as much by now) of investors who are scared of the rising interest rate environment. There is good reason to consider restructuring your portfolio in accordance with the bigger picture. However, in our view, the selling might have gone too far, and there are candidates from this sector for a mean reversion trade at the very least.

Based on the data that I have reviewed, MUE can be a potential “Long” addition to your portfolio.

Trade With Beta

At Trade With Beta, we also pay close attention to closed-end funds and are always keeping an eye on them for directional and arbitrage opportunities created by market price deviations. As you can guess, timing is crucial in these kinds of trades; therefore, you are welcome to join us for early access and the discussions accompanying these kinds of trades.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MUE over 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.