An example of how we analyze potential investment ideas using a mix of qualitative and quantitative methods. In this case a look at the high-grade tax-exempt bond market and closed-end funds of tax-exempt debt.

1. 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?
Figure 1
2.2
This is a tough question to answer
2
because there really is no such thing as a
1.8
monolithic “muni bond” complex. Bonds are
1.6
split amongst at least 4 major categories, tens
Pre-crisis
1.4
of tenors, and at least 4 major rating brackets
GFC
1.2
Post-crisis
(we eschew analysis of the speculative-grade
1
market as this market is primarily composed
0.8
of conduit deals, not municipals). Because of
0.6
the hundreds of permutations observable, it is
1.25
3.25
5.25
7.25
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.
1

2. Figure 2
Our model indicates that as-of July 31st, the
100%
BFV 10yr bond yielded 0.40% more than our
expected yield, or about 2.2 standard80%
deviations. Figure 3 illustrates a long-term
60%
time series of our predicted AAA yield and the
observed yield. Figure 4 represents the
40%
difference between the expected and
observed yields. A positive number indicates
20%
that yields are higher than we expect them to
0%
be and a negative number that yields are
-0.75
-0.25
0.25
0.75
1.25
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 AAindex 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
2

3.
3
Mar‐13
Mar‐12
Mar‐11
Mar‐10
Mar‐09
Mar‐08
Mar‐07
Mar‐06
Mar‐05
Mar‐04
Mar‐03
Mar‐02
Mar‐01
Mar‐00
Mar‐99
Mar‐98
Mar‐97
Mar‐96
Jan‐13
Jan‐12
Jan‐11
Jan‐10
Jan‐09
Jan‐08
Jan‐07
Jan‐06
Jan‐05
Jan‐04
Jan‐03
Jan‐02
Jan‐01
Jan‐00
Jan‐99
Jan‐98
Jan‐97
Jan‐96
1.50
Jan‐95
2.00
Mar‐95
1.4
Jan‐94
Jan‐93
Jan‐92
2.50
Mar‐94
1.6
Mar‐93
Mar‐92
Mar‐91
Figure 3
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00
Modeled Yield
BFV AAA GO 10y
1.25
0.25
Figure 4
‐0.75
Figure 5
AA‐ to A‐
AAA to AA‐
1.2
1
0.8
0.6
0.4
0.2
0

4. 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.
Jan-98
Mar-02
May-06
Jul-10
May-12
Jan-13
Nov-93
Sep-11
Sep-89
May-10
Jan-11
Jul-85
Sep-09
May-81
Jan-09
Mar-77
May-08
Jan-73
Sep-07
Jan-07
Sep-64
Nov-68
May-06
Jul-60
Sep-05
May-56
4
Jan-05
Mar-52
May-04
Sep-03
Jan-03
Jan-48
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 Figure 6
tools to achieve its mandate of price
30.0
Loans and Leases in Bank Credit, All Commercial…
stability (currently defined as a 2%
25.0
symmetrical inflation target as
20.0
measured by the core personal
15.0
consumption expenditures deflator)
10.0
and full employment. At the time of
this writing, rate volatility appears to
5.0
have been triggered by discussions
0.0
of pulling back on quantitative
-5.0
stimulus. That is reducing the rate at
-10.0
which the Fed is easing, not
tightening. Our focus for the
3.0
purpose of this exercise, however, is
2.5
rate policy. Rate policy is primarily
2.0
used as a tool to disincentivise
borrowing by making it more
1.5
expensive. Assuming a negatively
1.0
sloped demand curve, a higher cost
Personal Consumption Expenditures Excluding Food
0.5
of borrowing will reduce the
and Energy (Chain-Type Price Index)
quantity of borrowing demanded
0.0
and constrain the banking system’s
function of money multiplication by
limiting velocity. Ultimately, this
Figure 7
leads to less credit-driven

5. 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 12month 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.” Rolldown 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.
5

6. About Tax-Exempt Bond Interest Rate Sensitivities
BFV AAA GO 10y Yield
In the section titled “Are
Figure 8
tax-exempt bonds expensive?” we
6.5
briefly discussed tax-exempt bond
6
yield ratios and the relationship
5.5
between treasury yields and tax5
exempt yields. A more technical
4.5
review of their relationship can be
4
y = 0.5929x + 1.1914
seen in Figure 8, which illustrates
3.5
R² = 0.9326
the highly linear relationship
3
2.5
between tax-exempt bond yields
2
and US Treasury yields. As the
1.5
coefficient of the simple (yet
1
3
5
7
9
highly explanatory) linear
10y US Treasury Yield
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.
6

7. Figure 9
1.80%
7%
US Muni General Obligation AAA
1.60%
6%
US Muni General Obligation AA-
1.40%
5%
US Muni General Obligation A-
1.20%
4%
3%
US Muni General Obligation BBB
1.00%
0.80%
0.60%
US Muni General Obligation AAA
US Muni General Obligation AAUS Muni General Obligation AUS Muni General Obligation BBB
2%
1%
0%
0
5
10
15
20
25
0.40%
0.20%
0.00%
0
30
5
10
2.50%
8%
7%
5%
20
25
30
US Muni General Purpose AAA Cu
US Muni General Purpose AA+ Cu
2.00%
6%
15
US Muni General Purpose A- Cur
US Muni Revenue BBB Curve
1.50%
4%
1.00%
3%
US Muni General Purpose AAA Cu
US Muni General Purpose AA+ Cu
US Muni General Purpose A- Cur
US Muni Revenue BBB Curve
2%
1%
0%
0
5
10
15
20
25
0.50%
0.00%
0
30
9%
1.60%
7%
1.40%
6%
1.20%
5%
1.00%
4%
10
1.80%
8%
5
15
20
25
30
0.80%
3%
1%
0%
0
5
10
15
20
25
US Muni Bank Qualified AA- Cur
US Muni Bank Qualified A- Curv
US Muni Bank Qualified BBB- Cu
0.60%
US Muni Bank Qualified AAA Cur
US Muni Bank Qualified AA- Cur
US Muni Bank Qualified A- Curv
US Muni Bank Qualified BBB- Cu
2%
US Muni Bank Qualified AAA Cur
0.40%
0.20%
0.00%
30
0
7
5
10
15
20
25
30

8. Closed-End Funds
As we feel we have sufficiently documented how we came to the conclusion that investmentgrade 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.
8

9. Weighted-average share price as % of NAV
9
Oct-12
Oct-11
Oct-10
Oct-09
Oct-08
Weighted-average share price as % of NAV
Oct-07
Oct-06
Oct-05
Oct-04
Oct-03
Oct-02
Oct-01
Oct-00
Oct-99
Oct-98
Oct-97
Oct-96
Oct-95
Oct-94
6/11/13
4/11/13
2/11/13
12/11/12
10/11/12
8/11/12
6/11/12
4/11/12
2/11/12
12/11/11
10/11/11
8/11/11
6/11/11
4/11/11
2/11/11
12/11/10
10/11/10
8/11/10
6/11/10
4/11/10
2/11/10
12/11/09
10/11/09
8/11/09
Figure 10
3.5
140%
3
130%
2.5
120%
2
110%
100%
1.5
90%
1
80%
0.5
70%
0
60%
Skew of index composition
Figure 11
3
140%
2.5
130%
2
120%
1.5
110%
1
100%
90%
0.5
80%
0
70%
-0.5
60%
Skew of index composition

10. Why do fund prices vary so much?
Aug-12
Feb-11
Aug-09
Feb-08
Aug-06
Feb-05
Aug-03
Feb-02
Aug-00
Feb-99
Aug-97
Feb-96
Aug-94
Feb-93
Aug-91
There is no clear explanation to the Figure 12
major discount cycles, which tend to last
about 4 years from trough to peak and 1210
18 months from peak to trough. As-of July
st
31 , 10 full months had elapsed since the
5
latest peak in the cycle with the weighted
0
average discount for the observed universe
-5
increasing by 10.24% in that time period,
-10
roughly the same as the average peak-to-15
trough for the five observed cycles in Table
-20
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
Aug-93
Dec-94
Dec-98
Dec-99
Jun-03
Apr-04
Apr-07
Nov-08
Sep-12
Jul-13
Average
Peak Value
102.10%
102.25%
97.50%
99.23%
103.34%
100.58%
Trough Value
90.00%
89.15%
91.30%
87.65%
93.10%
90.30%
Total Decline Length
-12.10%
16
-13.10%
12
-6.20%
10
-11.58%
18
-10.24%
10
-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%.
10

11. 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
11