RFMZ: Discount Narrows Making It Less Appealing

RiverNorth Flexible Municipal Income II (RFMZ) is a closed-end fund investing in municipal bonds and other muni CEFs, characterized by high leverage (41.6%) and a substantial effective expense ratio (4.76%). While offering an 8.01% distribution yield, the fund's payout is largely uncovered by net investment income and includes significant return of capital, making it less appealing for investors seeking pure tax-exempt income. The fund's discount has narrowed, reducing its relative attractiveness compared to sister funds like RMI, which currently offers a wider discount but has historically struggled with total returns in the high-interest rate environment due to its leveraged structure.

Analysis

RiverNorth Flexible Municipal Income Fund II (RFMZ) is a leveraged closed-end fund with a complex structure, investing in both individual municipal bonds and a portfolio of other muni CEFs. The fund's high leverage of 41.6% and an effective expense ratio of 4.76% (including financing costs) present a significant headwind in the current rate environment. The cost of leverage, at 4.10% plus operating expenses, currently exceeds the 3-4% yield on the underlying municipal bonds, indicating that leverage is a drag on net investment income. Consequently, the fund's attractive 8.01% distribution yield is not covered by earnings, as shown by the NAV distribution rate rising to 7.39%. This shortfall results in distributions being heavily comprised of Return of Capital (ROC), which is tax-deferred rather than tax-exempt, reducing an investor's cost basis and creating a future tax liability. From a valuation perspective, RFMZ's appeal has diminished as its discount to NAV has narrowed to -7.29% from previous double-digit levels, effectively closing the window on a prior successful swap opportunity against its sister fund, RMM. While another fund in the family, RMI, now offers a wider discount, its historical performance has been weak, highlighting the risks inherent in this leveraged strategy during periods of rising interest rates.

Key Decisions for Investors

• Investors should scrutinize the fund's high leverage and total expense structure, as current borrowing costs are a drag on net investment income and may continue to erode NAV.
• Those seeking tax-exempt municipal income should be aware that a significant portion of RFMZ's distribution is Return of Capital, which is tax-deferred and reduces cost basis, rather than providing pure tax-free income.
• Tactical investors should note that the relative value opportunity versus sister fund RMM has largely dissipated, and while RMI offers a wider discount, its historical performance suggests caution is warranted before rotating capital into it.