- The majority of the fund's holdings are in investment-grade credit, which I view favorably given the challenging economic climate.
- NEA is well diversified across U.S. states and also offers buyers a compelling discount to NAV at these levels.
- The income yield remains attractive, especially on a tax-adjusted basis. While a distribution cut in the future concerns me, I think even with a cut this fund will generate investor interest.
Main Thesis & Background
The purpose of this article is to evaluate the Nuveen AMT-Free Quality Municipal Income Fund (NYSE: NEA ) as an investment option at its current market price. This is a multi-state, closed-end fund with an objective "to provide current income exempt from regular federal income tax and the alternative minimum tax applicable to individuals by investing in an actively managed portfolio of tax-exempt municipal securities."
I have owned NEA for a long time and have recommended it many times over the year. However, in mid-2021 I shifted to a more cautious outlook as I was worried about inflation and impending interest rate increases. This caution turned out to be vindicated, but I admit I became bullish again a bit too early. Munis had been seeing a lot of weakness, and towards the end of Q1 this year I began to see some value. Unfortunately, the muni sector continued to see declines and only more recently began to see sustained weeks of gains. While my most recent buy call was a little bit early, readers should also consider that NEA ended up being a reasonable equity hedge in the interim anyway, as shown below:
This suggests to me that munis are back to doing what they are supposed to do - provide income and act as an equity hedge. With the broader market dropping sharply, NEA has held up well. So while it did not deliver gains and completely vindicate a "buy" rating since March, it held up reasonably well.
With this backdrop, I wanted to do another review of NEA to see if anything material has changed. After some thought, I continue to see a favorable backdrop. I believe this fund has plenty of merit for adding to my position in the second half of the year, and I will explain why below.
Some Negative Headlines Are Misleading
To start, I want to give some context on the broader muni sector as a whole. This is important because state and local budgets have come in to headlines more and more since the Covid-19 pandemic got underway two years ago. There were risks and concerns about widespread muni defaults if the pandemic shuttered businesses, people stopped spending, and we entered a severe recession.
Well, a lot of those things did happen - small businesses closed, people lost jobs, and economic growth slowed. Yet, muni debt held up pretty well. This was due to a number of factors, including substantial federal aid and resilient tax collections. While unemployment did tick up, households received massive amounts of stimulus which kept sales tax receipts at elevated levels - this was not predicted early on during the pandemic. Further, property values have continued rising and mortgages kept on being paid, which allowed local governments to collect high levels of property taxes. All things considered, state and local governments have come out from this pretty well off.
Despite this, I continue to see negative headlines at least weekly with respect to muni debt. But I personally believe these articles are attention grabbing and lack substance. For example, I recently read how state pension funding has taken a hit. In fairness, state and local government funding for pensions has been a sore spot for me politically and as a muni investor for some time. So there is plenty of merit to monitoring those metrics. Yet, the current environment is hardly reason for panic. Yes, funding levels have dropped because of the market sell-off this year - which was the reason for the article. But let us give this some perspective. While the percentage of pension funding has dropped from 2021 levels, it is still elevated compared to the average over the past decade, as shown below:
What this is showing is that while the funded ratio is in decline, it remains well within historical range. Further, much of this has to do with broad market declines and not idiosyncratic issues within state and local governments themselves (i.e. spending recklessly, over hiring, etc.). With the equity market already rebounding in July, I expect this ratio will improve in the short-term without any action being needed. While the longer term picture still needs to be improved by getting the ratio in to the 90-100% range, there is no need for real concern at this moment.
Income Not At Risk Now, But It Could Be
The next topic I want to focus on is NEA's distribution. This is certainly a critical attribute for a muni fund, since most investors buy this for tax-free income. With a current yield over 5%, this is indeed very attractive on a tax-adjusted basis - even with inflation being where it is. When I consider that the underlying debt is of investment-grade quality, I feel really comfortable taking on the risk this fund offers to earn that type of yield.
With that said, readers should recognize the pressure the current macro-environment is putting on this fund, and leveraged CEFs in particular. This is a topic I have focused on in a few of my most recent reviews, so I won't dive in to too much detail here. But suffice to say that in a rising interest rate environment, a high inflation rate environment, and an inverting yield curve environment, all of these factors pressure income production.
Now, I don't want to be alarmist here. NEA has a strong history of paying its distribution level, and the most recent UNII metrics show that this story has not changed much in the short-term. Specifically, the fund has a coverage ratio very close to 100%, as well as a UNII balance that covers almost three months worth of distributions:
This picture shows that NEA's current distribution is not at risk right now. That provides a reasonable level of assurance.
However, I have a few concerns longer term for a couple of reasons. One, we have seen a number of cuts across the leveraged CEF space already, so that should keep investors aware of the potential for the funds they own. With particular respect to NEA, a comparable fund from Nuveen recently saw a distribution cut in its July distribution. This fund, the Nuveen Quality Municipal Income Fund ( NAD ) is one that I used to own in the past, and is not vastly different from NEA. While they are different funds, seeing NAD cut its distribution by roughly 9% so recently gives me pause:
Again, this is a different fund, so we cannot necessarily extrapolate this development to NEA. However, it does cause me to reflect on the broader economic environment and why cuts like this are not too surprising.
For example, leveraged CEFs borrow money at short-term rates to reinvest that money in to longer dated securities. This is advantageous, but the dynamic can breakdown during times of yield curve inversion. This is because short-term rates are rising faster than long-term rates, forcing the fund to pay more in expenses to borrow but limiting the yield pick-up they receive by investing those borrowed funds. This is an important concept at the moment, because the treasury yield curve has inverted a couple of times already in the current calendar year:
This is meant to simply be a word of caution. This an inverted yield curve environment, the market is distorted. This can pressure leveraged CEFs in a unique way, and NEA is no exception to this. While recent income metrics are strong, readers should continue to assess the broader muni credit backdrop and further yield curve developments and factor that in to their distribution analysis. If the inversion persists, an income cut is a likely scenario.
That said, it does not deter me from holding on to this fund for two reasons. One, there is a possibility it won't happen and the risk is a moot point. Two, NEA's income is attractive enough that it can survive a cut and still offer a strong tax-adjusted income distribution. So while some caution is worth noting, it is not enough to deter me from owning it.
Despite Recent Momentum, Munis Still Unloved
I will now touch on a key reason I believe there is still value in munis right now, and NEA by extension. Importantly, this is an area that is still seeing fading interest from the broader market. While that sounds counter-intuitive, the best times to buy/initiate positions in a healthy sector is when it is unloved. With respect to munis, this has been most of 2022. But what is surprising to me is that outflows have continued through June, despite the sector finally pumping out some gains. For perspective, consider the two graphics below: the first is muni fund flows for the past year, which shows continued outflows through June, the second showing NEA's 1-month performance:
What I am trying to illustrate here is that despite some positive momentum recently, munis are still not generating much investor interest. Outflows have scaled back, that is true, but I would expect inflows given this environment, and that is not happening yet. I would suggest readers front-run the market here, as I expect munis to gain favor in the second half of the year and we will want to preempt that.
NEA looks like a reasonable way to do so in my view because I not only see value in the muni space as a whole but I continue to see it with this CEF. The fund remains in heavily discounted territory, trading at a discount to NAV in excess of 6%, as shown below:
My takeaway is to keep on riding on the rising ship, but to do so with value positions. NEA offers this, and its discount continues to intrigue me. When I couple this with my contrarian nature to bet on sectors that the public is selling, I see plenty of merit to holding and/or adding to this fund.
Keep An Eye On The Health-Care Exposure
My last topic touches on the underlying holdings on NEA. When investing in this fund, one would want to have a reasonable outlook on the Health Care space, in terms of financial stability. That is because this is the fund's largest individual sector by weighting, clocking in at over a quarter of total assets:
This could be worrisome to some readers, as this is one of the more troublesome spots in the muni market. Some others being transportation (which has dramatically improved over the past year, and higher education). While the muni market rarely sees defaults, we should recognize when they do happen they are often concentrated in the Health Care sector, as shown below:
With this in mind, why would one want this exposure, and NEA by extension? Wouldn't it make sense to buy something with less Health Care exposure, and is therefore a safer bet?
While I would never presume to encourage someone to buy in to a sector they did not feel comfortable with, I want to explain why this does not deter me with respect to NEA. There are a number of reasons for this. One, while Health Care related defaults make up a vast percentage of overall muni defaults, they still are low in number. In all of 2021 there were about 25, which is not extreme. Two, these defaults were concentrated primarily in the high yield sector. While NEA does have some below-investment grade and non-rated debt, the bulk of the fund's holdings are of very high quality:
Beyond this generic break-down, we have to remember that Health Care can mean a lot of things. While the default graphic just showed "Health Care" was responsible for the defaults, the primary driver of this is senior living bonds . This includes assisted living facilities and the like. This is not surprising, as the sub-sector has been hit hard by covid, and they are currently dealing with below-average occupancy, high expenses, and a labor shortage. While troublesome, this is not the type of exposure NEA really holds. As the first graphic in this paragraph shows, less than 2% of the fund's underlying holdings are in long-term care. The bulk of the Health Care exposure is coming from city hospital systems, specialty medical providers, and community health care systems. Below are examples (pulled from NEA's individual holdings list):
Therein lies the difference. Many of these are not-for-profit health care networks that often receive federal, state, and local funding for their operations since they serve the wider community. This differs immensely from the for-profit senior living residencies that have seen the bulk of the defaults. So, in summary, while "Health Care" remains a trouble spot for the muni sector, investors need to be disconcerting when evaluating their exposure. To me, NEA holds the right stuff.
Bottom-line
NEA has been a long standing position in my portfolio for a while now. Late last year I started to reduce my position, but as the sell-off in 2022 got underway I built it back up. I was admittedly a little early, but I am using the second half of the year to continue to build this position up. The broader muni market looks favorable to me, NEA has a steep discount to NAV, and its strong credit quality puts me at ease with financial conditions tightening. In my opinion, NEA will see continued gains heading in to 2023, and I would encourage readers to give this CEF some consideration at this time.
For further details see:
NEA: Can This Fund Keep Moving Higher? Reasons Why I Think So