2024-01-04 11:09:44 ET
Summary
- Nuveen Municipal High Income Opportunity Fund offers a 5.13% yield, which is equivalent to an 8.14% yield for investors in the top tax bracket.
- The NMZ closed-end fund's shares have declined by 16.33% over the past five years, performing poorly compared to the ICE AMT-Free US National Municipal Index.
- The fund invests in municipal securities rated Baa/BBB or lower, with a significant portion invested in unrated securities, which poses some risk.
- The December FOMC minutes are strongly hawkish, which suggests that bonds are going to decline in the near future when and if the Fed disappoints on rate cuts.
- The fund has failed to cover its distribution for two straight years and has been raising capital to no avail.
The Nuveen Municipal High Income Opportunity Fund ( NMZ ) is a closed-end fund, or CEF, that investors can employ in order to generate a high level of income from the assets in their portfolios. As is the case with most municipal funds, this fund is best utilized by investors in the highest tax bracket, as the yield is too low to offer an attractive return to investors who do not have to worry as much about taxes. At the current price, the fund offers a 5.13% yield, which is certainly not very attractive on the surface. However, here are the yields that would be needed in order to earn an equivalent level of income by investing in ordinary taxable closed-end bond funds:
Tax Bracket | Tax-Equivalent Yield |
10% | 5.70% |
12% | 5.83% |
22% | 6.58% |
24% | 6.75% |
32% | 7.54% |
35% | 7.89% |
37% | 8.14% |
Thus, for investors in the top tax bracket, it would be necessary to invest in a fund with an 8.14% yield in order to earn the same level of after-tax income that this fund provides. That pretty much means that you would have to be buying a junk bond fund, and junk bonds are naturally going to have a much higher risk of default losses than municipal securities. After all, municipal securities are typically backed by municipal governments, and they have the authority to impose taxes as necessary to satisfy their debt obligations. At least, that is the basic thesis surrounding most government-backed debt securities.
Investors who are not in the top tax brackets though, or anyone who intends to use an individual retirement account or similar vehicle to purchase a fund, would be better off buying an ordinary closed-end bond fund, as the tax advantages from this fund are not going to be sufficient to compensate for the lower yield that it offers compared to anything that invests in ordinary corporate bonds or U.S. Treasuries.
Unfortunately, the Nuveen Municipal High Income Opportunity Fund does not appear to offer a great proposition to investors. As we can see here, the fund’s shares have declined by 16.33% over the past five years. This compares quite poorly with the ICE AMT-Free US National Municipal Index ( MUB ) over the same time period:
Indeed, the national municipal bond index has held up remarkably well despite the fact that interest rates swung quite a few times over this period. We can see the impacts of that reflected in the price performance of the Nuveen Municipal High Income Opportunity Fund, but not so much in the index that has remained relatively stable.
However, as I have pointed out numerous times, the price performance of closed-end funds is somewhat misleading because of the way that these entities work. In short, a closed-end fund pays out essentially all of its investment profits to the shareholders in the form of distributions. This is what results in them having very high yields. In many cases, these distributions can be large enough to offset moderate declines in the share price. As such, we need to include the distributions in the performance chart to determine how well investors actually did during a given period. When we do that, we see that investors in the Nuveen Municipal High Income Opportunity Fund received a 9.66% total return over the trailing five-year period. This was just a bit better than the return that was delivered by the index:
Thus, so far this fund appears to be a reasonable investment. Let us take a closer look at it though and attempt to determine if it could be worth considering for investors who are highly sensitive to tax considerations.
About The Fund
According to the fund’s website , the Nuveen Municipal High Income Opportunity Fund has the primary objective of providing its investors with a high level of current income that is exempt from Federal income taxes. This makes a lot of sense considering the fund’s basic strategy. As the website explains,
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, or unrated securities judged by the manager to be of comparable quality. No more than 10% of the Fund’s managed assets may be invested in municipal securities rated below B3/B-, or that are unrated by judged by the manager to be of comparable quality.
Thus, this fund is essentially a municipal junk bond fund, but it is not as bad in terms of credit quality as some of the corporate junk bond funds that we have discussed in this column. In particular, note how the fund’s documentation specifically states that it will normally be invested in securities that carry a BB or a B rating. At the moment, the fund might or might not be compliant with this rule as more than half of its assets are invested in unrated securities:
As we can see, 53.8% of its assets are invested in unrated securities. The description on the website basically states that these are securities that the fund manager believes are equivalent in quality to BBB, BB, or B-rated securities but there is no guarantee that this is the case. Of the securities that are rated though, we do see that they generally have ratings that are BB or higher.
This could help alleviate some of the concerns that income-focused investors frequently have with respect to high-yielding investments. In a very low-interest rate environment, such as what we have had over most of the past twenty years, most things with high yields are quite risky. This is the reason for the high yield, as the market is terrified that there is a very high risk of losing your money due to default or some other reason. According to the official bond rating scale , anything with a B rating or higher has a strong enough balance sheet to carry its existing debt even in the event of a short-term economic shock. Thus, the assets in the fund should be at fairly low risk of default, although the risk is certainly not zero as we would theoretically have with Treasury securities. Of course, this statement depends on the unrated securities having similar risk profiles to the rated ones in the fund and there is no real way to determine if this is the case.
The fact that municipal bonds can have junk ratings at all might be surprising to investors who are inexperienced with municipal bonds. After all, these bonds are issued by governments, and governments are typically considered to be very safe debtors due to their ability to levy taxes on the people who work and reside within their borders. In addition, governments face few competitive threats when compared to corporations or private borrowers. However, it is important to keep in mind that municipal bonds are frequently issued to cover the construction of various public works projects and they are backed only by the revenues generated by these projects.
There are certainly plenty of cases in which these public works projects make absolutely no economic sense. For example, Joe Mysak Jr., a columnist for Bloomberg covering municipal bonds discussed a few ridiculous municipal bond issues that he has seen over his career in an article that he published last year:
Of course, the 1990s were a particularly frothy period in public finance, when it looked like retail investors would buy almost anything in the municipal market. One of my prized relics from the time is a banker’s presentation from that same conference that lays out the details of a number of proposed transactions, including the Las Vegas monorail (financed and went bust) and a theme park called the Wonderful World of Oz, to be built, of course, in Kansas (unfinanced).
Thus, there have been cases in which municipal bonds are issued to fund ridiculous things and then end up in default when the dreams of government officials fail to result in profitable economic activity. It is certainly possible that this fund contains some issues like this. Here are the largest positions in the fund:
Energy Harbor Corporation is an Ohio-based company that provides renewable energy to about one million people in the mid-Atlantic region. A few of the states in that area are deregulated, and this company is one of several power providers in the area. While there is no guarantee that this is a safe investment, it is probably much safer than a theme park based on The Wizard of Oz . The company is private and does not provide information to the public about its financial condition, but it should probably be able to at least make debt payments if it really does have a million customers.
The other entity that we see here that represents a significant holding in the fund’s portfolio is the Florida Development Finance Corporation. This entity is a conduit for issuing all sorts of municipal bonds throughout the state of Florida. As such, these bonds might be revenue bonds that cover a single project, they might be general obligation bonds backed by the ability of a local government to tax its citizens, or they might be securities backed by pools of loans issued by municipal governments in the state of Florida (similar to mortgage-backed securities or collateralized loan obligations). There is no real way to tell exactly what this money is intended to finance, but it is probably still safer from default risk than some securities that we occasionally see in the municipal bond market.
Another strategy that this fund is using to limit its risk of losses in the event of default is investing in a large number of different issuers. The fund currently has 825 separate holdings in its portfolio, which should ensure that most individual issuers only account for a very small portion of the overall fund. As we can see above, there are one or two positions that account for more than 2% of the portfolio but overall, nearly everything in the fund represents less than 1.5% of the portfolio. Thus, if any single issuer defaults, it will probably not have a large enough impact on the fund as a whole for it even to be noticed.
While default risk probably is not worth losing sleep over, we do need to worry about interest rate risk. This is because municipal securities are bonds and as such their prices move inversely to interest rates. This is something that has had a huge impact on the fund over the past few months. On October 19, 2023, the ten-year U.S. Treasury bond (US10Y) peaked at a 4.988% yield and has steadily declined since that time. This decline has been partly due to investor optimism that the Federal Reserve would rapidly reduce interest rates over the course of 2024, which is the same optimism that drove rallies in just about every other asset class except for the U.S. dollar. The Nuveen Municipal High Income Opportunity Fund has benefited from this as well, as its shares are up 15.58% since October 19, 2023:
The fund’s net asset value per share is up 17.39% over the same period, which suggests that this rally was driven by rising bond prices and not simply trend-chasing. The fact that the fund’s net asset value has been outperforming the share price could also prove very appealing to certain investors as it suggests that the fund’s shares may be undervalued right now. We will discuss that later in this article.
However, the market may have gotten ahead of itself. Current market pricing suggests that the Federal Reserve will reduce the federal funds rate at six of its eight meetings starting with the March meeting:
However, this seems to be highly unlikely to happen unless the American economy falls into a very severe recession within the next month. The minutes from the December meeting of the Federal Open Market Committee are far too hawkish to support this scenario, which probably explains some of the market weakness that we saw in today’s trading session. Indeed, there were even some comments that suggest that a rate hike is more appropriate than rate cuts if the market continues to ease financial conditions. As Zero Hedge correctly points out:
These Minutes in no way support a 150bps rate-cut next year.
Any scenario in which the Federal Reserve does not cut the federal funds rate by 150 basis points will almost certainly cause this fund to give up all of the gains that it made over the past two months. In fact, if the Federal Reserve does not cut the federal funds rate in March, which the minutes suggest is a very strong possibility, then a correction seems essentially certain. This suggests that investors may be best served by taking their gains today and waiting until a correction to re-enter the fund.
Leverage
As mentioned earlier in this article, the Nuveen Municipal High Income Opportunity Fund employs leverage as a method of boosting the effective yield beyond that of any of the underlying assets in the fund. This is a very common strategy that is employed by closed-end funds that allows them to deliver the high yields that they are known for. I explained how this works in a variety of previous articles. To paraphrase myself:
In short, the fund borrows money and then uses that borrowed money to purchase municipal bonds that have junk ratings. As long as the yield on the purchased securities is higher than the interest rate that the fund has to pay on the borrowed money, this will usually be the case. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates. As such, this will usually be the case. With that said, though, the use of leverage to boost a fund’s effective yield is not as effective today with interest rates at 6% as it was a few years ago when interest rates were basically 0%.
However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund does not employ too much leverage because that would expose us to an excessive amount of risk. I generally prefer a fund’s leverage to be under a third as a percentage of its assets for this reason.
As of the time of writing, the Nuveen Municipal High Income Opportunity Fund has leveraged assets comprising 38.59% of its portfolio. This is considerably above the one-third level that I would normally prefer to see a closed-end fund employ. However, fixed-income funds are generally able to support a higher degree of leverage than equity funds due to the fact that their assets are less volatile. Ultimately, it is volatility that can cause problems for any sort of leveraged strategy because a moderate decline in asset valuations can cause enormous losses. In the case of municipal bonds, the volatility should be even less than it is for corporate bonds because they are normally perceived to be less risky. That is not always the case though, as we saw earlier in this article. Still, the fund’s leverage is probably okay right now, but we certainly do not want it to get any higher. This is something that we should keep an eye on going forward, especially if bond prices do correct in the very near future.
Distribution Analysis
As mentioned earlier in this article, the primary objective of the Nuveen Municipal High Income Opportunity Fund is to provide its shareholders with a high level of current income that is exempt from federal income taxes. In pursuit of this objective, the fund invests in a portfolio that primarily consists of high-yield municipal bonds that have credit ratings that are somewhat less than investment-grade. These bonds naturally pay a higher yield than ordinary municipal bonds and when we consider the tax benefits, the bonds have a very competitive yield to taxable junk bonds. The fund collects all of the payments that it receives from these securities and even uses leverage to collect payments from more securities than it could ordinarily control by relying solely on its own equity. The fund combines this with any profits that it manages to make by exploiting changes in municipal bond prices that accompany interest rate swings. Finally, it pays all of this money to its shareholders, net of its own expenses. We might expect that this would give the fund’s shares a pretty high yield.
This is certainly the case, as the Nuveen Municipal High Income Opportunity Fund pays a monthly distribution of $0.0425 per share ($0.51 per share annually), which gives it a 5.13% yield at the current price. This does not seem particularly impressive, but this yield is the equivalent of a taxable security paying an 8.14% yield if you are in the top tax bracket. Thus, it may be appealing to investors who are investing in taxable accounts and who have very high incomes.
Unfortunately, the fund has not been particularly consistent with respect to its distribution over the years. As we can see here, the fund’s distribution has varied quite a lot over time, but the general trend has been negative:
This history seems somewhat unlikely to appeal to any investor who is seeking to earn a safe and consistent income from the assets in their portfolios. The fact that the fund cut its distribution in November is likely to reduce its appeal even further. After all, nobody likes their incomes to decline during a time when the price of just about everything that we purchase is increasing at a very rapid pace.
However, it is important to keep in mind that a fund’s history may not necessarily be the most important thing for new investors. After all, anyone who purchases the fund’s shares today will receive the current distribution at the current price and will not be affected by any events that occurred in the past. The most important thing for a buyer today is how well the fund can sustain its current distribution. Let us investigate this.
Fortunately, we have a very recent report that we can consult for the purpose of our analysis. As of the time of writing, the fund’s most recent financial report corresponds to the full-year period that ended on October 31, 2023. This is one of the most recent reports that we have available from any closed-end fund, which is very nice to see. After all, this report will both cover the very strong market that we saw during the first half of the year as well as the weakening and rising yields that characterized the summer months. Thus, we have two very different market environments for bonds, and although the bonds held by this fund are municipal bonds, they do trade similarly to their corporate and Treasury cousins. This report should tell us how well the fund managed to take advantage of the euphoria that existed in the first half of 2023 as well as how well it weathered the bear market that followed this euphoric market.
During the full-year period, the Nuveen Municipal High Income Opportunity Fund received $101,779,100 in interest from the assets in its portfolio. It received no income from any other sources, so its total investment income was also $101,779,100. The fund paid its expenses out of this amount, which left it with $56,832,875 available for shareholders. That was, unfortunately, not enough to cover the $61,792,701 that the fund paid out in distributions during the period. The fund did manage to get fairly close to fully covering its distribution, but it still failed to fully cover its payout using its net investment income. That is disappointing for a municipal bond fund.
However, there are some other methods through which the fund can obtain the money that it needs to cover its distributions. For example, it might be able to earn some money by exploiting price fluctuations that come with interest rate changes. Realized capital gains are not considered to be investment income, but they do still represent money coming into the fund that could be distributed. Unfortunately, the fund failed miserably at this task. For the full-year period, the fund reported net realized losses of $66,935,786 but these were partially offset by $17,358,472 net unrealized gains. However, the fund still failed to cover its distributions overall and its net assets declined by $44,835,566 after accounting for all inflows and outflows during the period. This comes on the heels of a $311,767,327 decline in net assets during the previous fiscal year.
Thus, the fund has failed to cover its distribution for two straight years and even its capital-raising attempts (through the issuance of new shares) have failed to keep its net asset value stable. This certainly explains the recent distribution cut, as the fund’s destruction of its net assets means that the required return that it needs to generate to sustain the distribution is getting higher and higher. It remains to be seen if the fund can sustain its distribution at the new level, but I am not optimistic considering that 2024 will probably not be as good a year for bonds as the market expects.
Valuation
As of January 2, 2024 (the most recent date for which data is currently available), the Nuveen Municipal High Income Opportunity Fund has a net asset value of $11.14 but the shares only trade for $9.95 each. This gives the fund’s shares a 10.68% discount on net asset value at the current price. That is better than the 9.73% discount that the fund’s shares have averaged over the past month, so the price looks reasonable right now.
Conclusion
In conclusion, the Nuveen Municipal High Income Opportunity Fund does offer a very respectable yield for investors who need the tax benefits, but the after-tax yield is easily matched by a good floating-rate fund that does not have the risks that this municipal junk bond fund does.
The fund has seen two straight years of net asset value declines, with no guarantee that it can sustain the distribution even at today’s reduced level. More importantly, though, it seems doubtful that the Nuveen Municipal High Income Opportunity Fund will be able to hold onto its recent gains if the Federal Reserve fails to cut interest rates as the market expects. The minutes from the December meeting suggest that this will be the case. It, therefore, could be best to lock in the gains that the fund delivered over the past two months.
For further details see:
NMZ: Take Profits Now Before The FOMC Disappoints The Market