This is an update to a series of articles on municipal bond closed-end funds started in 2011. One fund I wrote about back in 2011 was NVN, a single-state municipal bond fund holding New York bonds.
For this report, I've selected the Nuveen NY AMT-Free Muni Fund (NRK). Recently Nuveen organized a mega-merger where six NY municipal bond AMT-Free CEFs were combined into one:
New NRK= NUN + NNF + NQN + NVN + NKO + old NRK
Why would you buy a single state municipal bond fund instead of a diversified national fund?
There are several reasons why you may want to do this:
- Municipal bonds are exempt from federal, state and city income taxes for local residents. If a New York City resident purchases any New York tax free bond, that income is exempt from federal, New York State and New York City income taxes. This is called "triple tax free."
Note that if that same NYC resident bought a Texas municipal bond, the income is exempt from Federal taxes, but he would still have to pay New York State and New York City income tax. The top marginal tax rate in NY State is currently a whopping 8.97%.
- Some investors live in subsidized or rent stabilized housing for people with low to moderate incomes. They may need to keep their federal and state taxable income below a certain level or else they could lose their low cost housing arrangement. New York City has several housing subsidy programs and many residents live in subsidized housing of one form or another.
- An investor may be reluctant to purchase a national municipal bond fund because they want to avoid investing in some states entirely. They can construct their own customized national fund by selecting only the specific single-state funds they want to own.
What is the disadvantage in buying a single-state fund?
The main drawback is lack of regional diversification. If the state economy suffers a severe setback, many bonds in the portfolio may suffer. There is also less of a selection of issues to buy compared with a national fund.
Why would you buy an AMT-Free municipal bond fund?
Many investors are surprised at tax time when a portion of what they thought was tax-free income is subject to the Alternative Minimum Tax or AMT. It is sometimes hard for muni bond CEF investors to avoid paying AMT because they are unaware of which funds or bonds within a fund are subject to the AMT.
Some muni bond funds hold private activity bonds among their holdings. These are bonds issued by municipalities to raise capital for private businesses like airports or waste disposal facilities. Income from these bonds is exempt from regular income tax but is NOT exempt from AMT.
I will be discussing 13 factors that I currently use to evaluate municipal bond closed-end funds. But since NRK is really a new fund now, some of the information is not available and must be estimated.
Factor #1: What is the distribution rate?
NRK will be a high quality fund and will have a distribution yield of 5.73%. Starting on June 1, it will pay a monthly dividend of $0.069 per share or an annual distribution of $0.828. This does not include distributions paid prior to June 1 which will go to holders of the pre-merger funds. For someone living in NY State in the top tax bracket, the tax equivalent yield is around 11%.
Factor #2: What is the likelihood the fund can raise its monthly dividend?
To determine this, I look at the Average Earnings/Current Dividend Ratio. This ratio tells you whether or not a fund is earning its current dividend. If the value is well above 100%, it means the fund can easily afford to raise its distribution rate.
Since the combined NRK is new, there is no historical data yet to determine whether it will earn its dividend. But the fund management recently issued a press release announcing a monthly dividend increase to 0.069. There will be considerable cost savings and economoes of scale due to the merger that allow the old dividend to be increased.
Factor #3: What is the expense ratio?
I look at the Baseline expense ratio which does not include leverage costs. The baseline expense ratio for the old NRK was 1.22%, but this is expected to drop due to cost savings from the fund mergers.
Factor #4: What is the discount to NAV?
NRK is currently selling at a -2.75% discount to NAV which is more than the 6 month average of -0.62%. The one year Z statistic is -0.42. So on a one year basis, the discount is about half a standard deviation less than the usual discount.
Factor #5: How much leverage is used, and what is the preferred share asset coverage?
The new combined NRK has effective leverage of 36%. The preferred asset coverage ratio is currently 331% which provides an adequate margin of safety. I would only be concerned if this ratio dipped below 225%.
Factor #6: What is the AMT exposure?
The new NRK will soon have an AMT percentage of zero. This factor is a strong positive for NRK and it may become the "go to" fund for NY muni investors looking for AMT-free income.
Factor #7: What is the credit quality?
I look at the breakdown of AAA, AA, A, BBB, Below BBB and Unrated. Within the AAA category, a higher percentage of pre-refunded bonds is a positive, because these bonds are effectively backed by the US government.
This is the ratings breakdown for NRK as of Feb. 28:
BB & Below
NRK is a very solid fund with an average credit rating around AA-. I like to see the lowest rating category below 10%, and NRK qualifies easily. The above percentages will change somewhat because of the merger, but the six funds that were combined had very similar fund profiles and portfolio allocations.
Factor #8: What is the interest rate exposure?
NRK has an effective duration of 8.25, but adjusted for leverage the effective duration is 12.51. This is about average, and I would prefer a somewhat lower leverage-adjusted effective duration 10.0. One way to manage this interest rate exposure is to combine NRK with other lower duration funds like senior loan funds or low duration unleveraged muni funds.
Factor #9: What is the call exposure?
Here is a table with the call dates for bonds in NRK:
NRK would have some call risk over the next few years if the average price of its bonds were selling above par. But the average price of its bonds is only 86.38, so there is little call risk. I am currently more concerned about rising interest rates than falling rates over the intermediate to longer term anyway.
Factor #10: For a national fund, what is the breakdown by state?
This is not a factor for single-state funds, but I do look at the number of bonds from Puerto Rico and Guam which are triple tax exempt in all state funds. I like to see the Puerto Rico percentage under 5%. The old NRK was slightly above that, but these percentages will change once the consolidated fund statistics are available.
Guam & NA
Factor #11: How good is the trading liquidity?
Since the merger earlier this month, the NRK trading volume has increased considerably and has recently averaged about 300,000 shares a day with an average dollar volume of about $4 million. The combined NRK now has about $1.3 billion in common assets ($1.8 billion in total assets). The high level of trading activity is now a strong positive for NRK and I believe this may cause the discount to shrink or a premium to develop in the future.
Factor #12: What percent of the portfolio is in housing-multi-family bonds?
Until recently the housing market was shaky, and I like to avoid funds where the housing multi-family sector is above 10%. NRK has only 1.4% in this category.
Factor #13: Fund Management
NVN is managed by Scott Romans who joined Nuveen in 2000. He specializes in managing municipal bond portfolios and has a MA and PhD from the University of Chicago.
Based on the above 13 factors, I believe that NRK is currently a good holding for high income residents or for anyone else looking for AMT-free muni CEF funds and wanting exposure to New York State. In the next few months we will start to see more complete information on the combined fund statistics which may attract more investors.
The high trading liquidity and asset size should be attractive to financial advisors and high net worth investors who need to trade larger size. Over time, this may cause NRK to sell at a premium over NAV similar to some of the Pimco muni bond closed-end funds.