NMCO - NMCO And NMZ: Two Previous Buy Ratings Dismantled By The FOMC

2023-10-04 09:00:00 ET

Summary

• Nuveen Municipal Credit Opportunities Fund and Nuveen Municipal High Income Opportunity Fund have experienced significant declines since 2021.
• Both funds aim to provide high current income exempt from federal income tax and seek total return.
• The future performance of the funds is uncertain due to the unpredictability of interest rates, but the FOMC does not anticipate a return to ultra-low rates.
• Both original ratings only worked until the FOMC started fighting inflation. NMCO now gets a Strong Sell; NMZ a Hold or swap Buy for NMCO.

Introduction

I completely missed the warning shot across the bow of the fixed income ship of funds. I admit I got several "Cs" in my college economic and banking classes nearly fifty years ago. The rising inflation rate in 2021 was deemed "temporary" by the government "experts", so maybe I can take some solace in that, though many WSJ editorials loudly disagreed and I'm a dedicated reader.

For my Nuveen Municipal Credit Opportunities Fund: Betting On Discount Shrinkage article in early 2021, I gave it a Buy rating for the reason in the title. That did occur and traders did okay. Later that year, realizing rates needed to climb, I wrote NMZ: A Good Choice For A Rising Rate World , also giving it a Buy rating for what others were predicting. The basis for that article was based on too little support and deserves a trip to the woodshed for me!

Since each article was published, the Nuveen Municipal Credit Opportunities Fund (NMCO) is down 12% (total return) and the Nuveen Municipal High Income Opportunity Fund (NMZ) is down over 25%. The same fate befell most fixed income funds, including those that invest in variable rate debt. Here, I compare each fund's current holdings composition with what it held when the original article was written and then attempt to predict (again) how they might perform in 2024 and beyond. The new predictions about where the FOMC is going are summed up with the phrase "higher for longer", which could be applied to the US inflation rate too.

Both are classified by Nuveen as High Yield National Municipal Bond CEFs.

Nuveen Municipal Credit Opportunities Fund review

Seeking Alpha describes this CEF as:

The Fund's primary investment objective is to provide a high level of current income exempt from regular U.S. federal income tax. The Fund's secondary investment objective is to seek total return.Under normal circumstances, the Fund will invest at least 80% of its Assets in municipal securities, the income from which is exempt from regular U.S. federal income taxes. Benchmark: S&P Municipal Yield TR USD.

Source: seekingalpha.com NMCO

Nuveen uses this description:

The Fund seeks to provide a high level of current income exempt from regular U.S. federal income tax and secondarily, total return. The Fund invests primarily in high yielding, low- to medium-quality municipal securities that, at the time of investment, are rated Baa/BBB or lower or, if unrated, are judged by the portfolio managers to be of comparable quality. No more than 30% of the Fund's managed assets will be in municipal securities rated CCC+/Caa1 or lower.

Source: nuveen.com NMCO

It should be noted that NMCO added two portfolio managers last April to aid the existing manager. The Fund uses leverage and has a 12-year term with the potential to convert to perpetual in 2031. The above webpage details that process but a casual read appears to place most, if not all, control of that in Nuveen's hands.

NMCO has a total investment exposure of $1.1b, which includes its assets, leverage assets, and a tender option. The common shares' cost is 440bps; total asset cost is 258bps. The Effective leverage ratio is over 43%, with a cost of 4.72%. The price Yield is 6.0%.

Holdings review

I am going to leave some holdings data for when I compare NMCO to NMZ later, but since ratings data differs the most, I am covering it for both in detail.

The investment-grade allocation lacks any AAA allocation. The non-investment-grade allocation is almost all in BB rated debt. At nearly 61% in non-rated debt, it is hard to judge the overall credit risk of the portfolio. That weight is almost twice the category allocation to non-rated debt. All that said, some high-quality issuers forgo the ratings expense as unnecessary to get the coupon they want. Only 4% of the bonds are insured against default.

Out of 409 bonds, the above Top 10 represent just under 26% of the portfolio. Energy Harbor is a common stock given to bond holders when the company filed for bankruptcy and is a top holding of many Nuveen funds. With rates probably peaking in 2024, only .32% of the portfolio matures before 2025, providing little funds to invest in new debt with higher coupons.

I list the Top states later but a note about Puerto Rico, the sixth largest exposure at 6.5%. Many of those bonds are from the Puerto Rico Electric Company and are all listed at the same price, $34.99, with maturities ranging over the next 40 years. The hit to NMCO is de minimis over the next few years though. About 30% of the PR non-power bonds have a listed price over $80, so some have better backing.

Distribution review

The Earnings/Distribution ratio helps explain three payment cuts in under a year and at its current level, more should be expected.

I cannot remember ever seeing a CEF with a negative UNII amount as NMCO currently has. A CEF's UNII balance equals the funds available, beyond current earnings, from which to make future distributions to shareholders. This balance over time can impact both future distributions and the fund's NAV. NMCO's UNII was 95% a year ago; was still at 87% in the spring. It is now below 62%! As far as I could find, 100% of the distributions came from income.

Price/NAV review

I used the Corporate BBB yield as I did not see that YCharts had a Municipal BBB chartable value. It does show how the price and NAV have a close correlation to this rate and why the CEF has done so poorly since the FOMC started fighting inflation with rate hikes. If post-COVID history repeats, those willing to hang tight might do well, but other factors worry me about this CEF.

The discount is approaching the 8% maximum NMCO seems to bottom at. It does have a favorable Z-score for this metric, but note NMCO seldom has sold at a premium.

Nuveen Municipal High Income Opportunity Fund review

Seeking Alpha describes this CEF as:

The Nuveen Municipal High Income Opportunity Fund is a closed-end fund that primarily seeks to provide high current income exempt from regular federal income tax and secondarily, seeks attractive total return consistent with its primary objective. The Fund invests in municipal securities that are exempt from federal income taxes; the Fund uses leverage. Up to 75% of its managed assets may be invested in below investment grade or unrated municipal securities judged by the manager to be of comparable quality, but no more than 10% may be invested in those rated below B3/B-. Benchmark: S&P Municipal Yield TR USD.

Source: seekingalpha.com NMZ

Nuveen uses this description:

The Fund's primary investment objective is to provide high current income exempt from regular federal income tax. Its secondary investment objective is to seek attractive total return consistent with its primary objective.The Fund invests in municipal securities that are exempt from federal income taxes; the Fund uses leverage. By investment policy, up to 75% of its managed assets may be invested in municipal securities rated, at the time of investment, Baa/BBB or lower by at least one nationally recognized statistical rating organization including below-investment grade securities. No more than 10% of the Fund's managed assets may be invested in municipal securities rated below B3/B-, or that are unrated but judged by the manager to be of comparable quality. Just under 5% of the portfolio is insured against default.

Source: nuveen.com NMZ

NMZ has a total investment exposure of $1.9b, which includes its assets, leverage assets, and a tender option. The common shares cost is 232bps; total asset cost is 166bps. The effective leverage ratio is just over 40% with a cost of 4.37%. The price Yield is 5.8%.

Last April, Daniel J. Close and Stephen J. Candido were named as the new portfolio managers of the Fund. These are the same managers now helping to run NMCO. I didn't see any language about this CEF having a term provision.

Holdings review

While not as much as NMCO, over 53% of the bonds here are also non-rated. Based on the CEF's policy, management has deemed most of those to be above B3/B- "rated".

Overall, NMZ average rating appears to be higher than NMCO's portfolio, especially those rated above BBB.

The Top holdings mirror what NMCO and many Nuveen Municipal CEFs hold.

The Top 10 positions are 17% of this portfolio even though NMZ holds twice the number of bonds as NMCO does. Like NMCO, very few mature before 2025 (0.5%), giving little natural opportunity to reinvest in higher yielding bonds. The exposure to Puerto Rico mirrors that of NMCO.

Distribution review

Like NMCO, NMZ is also showing a negative UNII amount though its coverage ratio is still reasonable but below water. It also has cut the payout three times in the past year.

A year ago, its coverage ratio was over 100% this time last year and was still there last spring. The current value is near 94%.

Price/NAV review

NMZ's longer history shows it has broken through the COVID price low and is hanging just above the GFC low. The longer history also shows the correlation to the BBB rate holding over a long time period.

NMZ shows a history of selling at a premium, whereas NMCO, in its shorter lifespan, seldom did. Looking at NMZ's complete history, you see the same picture. Except for the GFC and COVID crisis, NMZ's discount is at an extreme. Its Z-scores support that point too.

Then and Now

Combining data from the prior articles and 2020 Annual reports, plus current data, here is how both compare then and against each other now. First, a look at important allocations.

The biggest change geographic wise is the drop in both CEFs of their Puerto Rico holdings; most likely due to the damage from multiple hurricanes lowering the economic vitality of the island. Both increased their weight to Transportation bonds, hopefully bought while COVID depressed prices. Of note are California bonds that don't break into the Top 5 for NMCO and dropped from second to fourth for NMZ. Most are not issued by the state, but by entities within the state.

Looking at various values, I compiled the following.

I already mentioned that NMZ, despite having "High Income" in its name, holds twice the weight in investment-grade debt than NMCO holds. As might be expected based on the NAV drop, the average bond price for both CEFs moved from over $98 to under $83. The good point there is each portfolio has room to grow, though the long average maturity definitely ties that to the movement in interest rates. With rates where they are, the high Call exposure should not result in much turnover as there is probably little to gain by refinancing as the average coupon for bonds callable before 2025 is 5.85%, though there are some outliers.

Of major concern is the fact that the CEFs had seen their distribution coverage ratio drop, extremely so for NMCO which now is below the aforementioned 62%, almost half what it was when the first article on it was done in early 2021!

Portfolio strategy

Critical, as was shown in 2023-23, is predicting where interest rates are going over the next few years. Inflation projections are also important as the FOMC looks at that as a key input for setting the Fed Funds Rate.

This forecast shows rates peaking this winter and dropping 200bps from the peak by this time next year and another 300bps over the following year. The forecasts naturally diverge in the distant forecasts. Using the dot plot data, the FFR could fall as low as 3.4% or stay as high as 4.9% by the end of 2025, then in 2026, forecasts see it going as low as 2.5% or staying as high as 4.1%. The forecasts do suggest one certainty: The FOMC doesn't see the ultra-low rates of the decade before the Covid-19 pandemic returning any time soon. If true, long duration funds should do well. On the inflation side, one set of inflation data I found shows inflation forecasted at just over 2% for each year through 2028.

Current opinions

NMCO CEF: Strong Sell rating With an expense ratio that is very high, including what the Nuveen keeps for itself, plus a UNII ratio below 70%, there are better choices to play a recovery when interest rates retreat.

NMZ CEF: Hold or Buy to replace NMCO Fees are reasonable for a CEF and UNII coverage, when down from last year, is still respectable at 94%.

If you own other Municipal bond funds, CEF or otherwise, tax loss swapping should be considered. One might sell now and buy later after we see if the predicted FFR hike for later this year occurs.

Caveat: Remember how bad my crystal ball was when I first reviewed both of these CEFs. Just a word to the wise!

For further details see:

NMCO And NMZ: Two Previous Buy Ratings Dismantled By The FOMC