2023-10-14 09:00:00 ET
Summary
- Municipal Bond CEFs have historically wide gaps between price and NAV due to investor dislike of rate increases. Once the FOMC stops, these funds should recover.
- The NEA CEF is reviewed in detail as the start of a due diligence process investors are encouraged to complete.
- The NEF CEF is recommended for long-term investors, despite potential rate hikes. Delayed entry or use a swap trade with a similar fund an investor owns at a loss.
Introduction
Investor dislike for fixed income CEFs, especially Municipal Bond ones, is reflected in their historically wide gap between the price and Net Asset Value, or NAV. Thanks to the FOMC pushing short-term rates from 0% to 5% since early 2022, the Bloomberg Municipal Bond Index saw a negative 8.5% return last year, the worst since 1981! Municipal Bond CEFs did even worse, down 24.4% on market price, as the use of and increasing cost of leverage was a giant negative.
This too will pass once the FOMC stops using their control over the Fed Funds Rate to fight inflation. With 2024 being a very important national election year, they could see, as has occurred in similar years before, subtle pressure surfacing. Once rates peak, these long-duration CEFs should start recovering, with the possible bonus of the huge discounts closing.
In my recent article, NVG: Historic Discount Available Keeps My Buy Rating , I gave it a Buy rating but mentioned holders might want to sell to capture their loss and reinvest in another, similar Nuveen Municipal Bond CEF, with a suggestion that the Nuveen AMT-Free Quality Municipal Income Fund ( NEA ) should be considered. To aid that decision, I chose to update my last review of the NEA CEF ( article link ). With opinions indicating more rate hikes are coming, delaying a commitment is a consideration but for long-term investors, I again give the NEA CEF a Buy rating.
Nuveen AMT-Free Quality Municipal Income Fund review
Seeking Alpha describes this CEF as:
The fund's investment objective is to provide current income exempt from regular federal income tax, and alternative minimum tax ("AMT") applicable to individuals. It seeks to invest in securities that are rated Baa/BBB or better by S&P, Moody's, or Fitch. The fund formed on November 21, 2002 and benchmarks against the S&P Municipal Bond High Yield index.
Source: seekingalpha.com NEA
Nuveen's description states that NEA can invest up to 35% of the fund in non-investment bonds, those rated BBB or below. Their description includes the following statement:
Primarily investment grade portfolio with a focus on bonds and sectors the team believes are undervalued and may enhance Fund income and total return.
Source: nuveen.com NEA
NEA has $3.67b in Managed Assets and $6.2b in Total Investment Exposure. Effective leverage is just under 41%, with a recent cost of 4.57%. The market price yield is 4.37%. Investors saw the following fee structure as of: 31 Aug 2023.
COMMON SHARES | TOTAL FUND | |
---|---|---|
Management fees | 0.92 | 0.54 |
Other expenses | 0.05 | 0.03 |
Subtotal | 0.97 | 0.57 |
Leverage financing expense | 2.47 | 1.50 |
Total | 3.44 | 2.07 |
One year ago, the leveraging cost was only .88, indicating how FOMC policy is costing leveraged funds.
Holdings review
Nuveen hasn't posted the month recent monthly results yet so data is from the end of August but they do provide lots of useful data elements, starting with key characteristics.
When I compared this chart with the one in my article from last November, I see that the average bond price is up despite a year of rising interest rates. The average coupon is up 1bps but with little turnover that was not a surprise. Compared to a year ago, the rating allocations have moved little, except NEA now holds some CCC rated bonds where the default is very high.
nuveen.com ratings
Again reflecting the low turnover rate, the maturity schedule is little changed too.
nuveen.com maturity schedule
Over 31% of the portfolio is dependent on either general or limited tax revenue, either at the state or local level.
nuveen.com sectors
Top 15 holdings
With over 1200 bonds held, these bonds are only about 8% of the portfolio.
Distribution review
Nuveen provides key data around the distributions.
Like most CEFs, due to higher leverage costs, this CEF has cut its payout three times since the start of 2022. The current amount is the lowest that NEA has ever distributed. With a distribution coverage ratio of 97%, hopefully no more cuts! Unlike some other Nuveen Municipal funds, that ratio is only slightly lower than one year ago.
Price and NAV review
Except for the 2008-09 GFC, the price and NAV have never been this low. That low base helps explain the record depth of the fund's discount of the price to the value of the assets held, as shown in the next chart.
Again, except for the GFC, the current discount of just under 16% has never been wider. The Z-score also indicates the extreme level of this important factor.
Performance and risk review
I included the other two AMT-Free funds from Nuveen in the next chart.
- Nuveen AMT-Free Municipal Credit Income Fund ( NVG ) Recent article .
- Nuveen AMT-Free Municipal Value Fund ( NUW ) Recent article .
Long history favors NVG but more recent (<5yrs) has NEA as the best performer of these three similar CEFs. Since 2018, while the StdDev favors NEA over NVG, the Sharpe and Sortino ratios have NVG ahead. For investors liking small StdDev values, NUW was the clear winner since 2018.
Portfolio strategy
Industry experts explain these record level discounts are the result that these funds tend to own bonds with maturities of 15 to 20 years, which have been hit hard in the recent fixed-income markets sell off. Their use of leverage to enhance the yield has been crashed by leveraging costs now close to the coupons held by the fund. This has resulted in payout cuts, which investors hate. Even with the payout reductions, the average yield is approaching levels last seen in 2014, thanks to the market correction.
The above chart shows the price and NAV drops that started when the FOMC started pushing up interest rates. So the big question is when will the FOMC stop rising and maybe even cut rates? That could be delayed as "higher for longer" is the current mantra, resulting NEA dropping 8% over the past month.
Conclusion
Is the glass half full or half empty? One's view on the near-term direction of interest and inflation rates and where tax rates are going after the current rates expire in 2026 comes into play. Here I have two scenarios that resulted in the Buy rating for the NEA CEF.
- For those holding other Municipal Bond funds at a loss, selling one and picking up NEA allows tax loss capture. The AMT-free feature might provide a better after-tax yield than what they own now. In this scenario, the above mentioned factors do not really matter.
- The current discount was only seen for a brief time at the height of the 2008-09 GFC. While it has been over a decade, NEA has sold at a premium, almost doing so in mid-2021. While long-term investors might suffer short-term pain, NEA showed a 6% since-inception CAGR until the recent price and NAV drops. Conservative investors might delay investing until after the expected FOMC rate bump later this year.
For further details see:
NEA Offering Deepest Discount Among Nuveen Municipal CEFs