This is the first of a series of articles on specific municipal bond closed-end funds, and is a follow-up to my last article on asset location strategies. There is no “best” bond for everyone, since the selection of a municipal bond closed-end fund depends on the investor as much as the fund. Important factors are the state of residence, risk tolerance with regard to defaults, interest rate risk and volatility, trading liquidity, AMT exposure and desired distribution amounts.
I have selected the Nuveen Premium Income Municipal Fund 2 (NPM) for the first report, because it is a good core holding for many investors. It is a national muni fund with holdings in many states, has above average credit quality, good trading liquidity and low AMT percentage.
I will be discussing 14 factors you can consider when evaluating any municipal bond closed-end fund.
Factor #1: What Is the Distribution Rate?
Many closed-end investors look almost exclusively at the distribution rate. While this is a mistake, it is important to consider the distribution rate when you evaluate a fund, because so many other investors consider it so important.
In the current market, there are three “tiers” of national muni bond closed-end funds. The higher risk leveraged funds have distribution rates of 8% or more. The middle tier lower risk leveraged funds yield around 7%, and the safer, low volatility funds, which are mainly unleveraged, yield in the 5%-6% range.
NPM is a high quality fund in the middle tier and currently has a distribution yield of 7.06%. It pays a regular monthly dividend of $0.074 per share or an annual distribution of $0.888. This does not include a special year-end dividend of $0.005 paid at the end of 2010.
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.
For NPM, the average earnings over the last three months $0.0810, so the Average Earnings/Current Dividend ratio= 109.5%. Nuveen publishes a report with this ratio for all of their municipal closed-end funds. In the last Nuveen report from year-end 2010, the ratio varied from a low of 90.1% to a high of 109.5%. NPM has the highest ratio of any Nuveen fund. I consider this a highly favorable factor for NPM.
I also like to see a positive value for “Undistributed Net Investment Income” or UNII. This is the life-to-date balance of a fund’s net investment income less distributions. For NPM, the UNII per share is +0.2049 which is also quite positive.
Factor #3: What Is the Expense Ratio?
I look at the Baseline expense ratio which does not include leverage costs. NPM has a baseline expense ratio of 1.08% which is about average. Anything over 1.5% is a big negative.
Factor #4: What Is the Discount to NAV?
NPM is currently selling at a 5.1% discount to NAV which is slightly more than the 6 month average of 3%. The one year Z statistic is -0.55, or about half a standard deviation above average. Overall, this factor is a small positive for NPM.
Factor #5: How Much Leverage Is Used, and What Is the Preferred Share Asset Coverage?
In 2008, some leveraged closed-end funds got into trouble because they violated the Investment Company 1940 Act when their asset coverage for the preferred shares went below 200% and they were forced to liquidate portions of the fund at a bad time. NPM currently uses 41.03% leverage. The preferred asset coverage ratio is currently 300% which provides a large margin of safety. I would be concerned if this ratio dipped below 225%.
Factor #6: What Is the AMT Exposure?
NPM has an AMT percentage of 4.79%. This is well below average. I consider 10% AMT to be about average, and anything over 20% is high.
Factor #7: What Is the Credit Quality?
I look at the breakdown of AAA, AA, A, BBB, Below BBB & 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 NPM:
BB & Below
NPM is a very solid fund with an average credit rating around AA. I like to see the lowest rating category below 10%, and NPM qualifies easily.
Factor #8: What Is the Interest Rate Exposure?
NPM has an average duration of 12.90 years. This is a bit on the high side, and I would prefer a lower duration below ten years. But NPM can be combined with other lower duration funds in order to reduce interest rate volatility risk to a more acceptable level as needed.
Factor #9: What Is the Call Exposure?
Owning a callable bond is similar to owning a stock and writing a covered call against it. But with the callable bond, the option is embedded instead of external. The call option is owned by the issuer, and can have the effect of taking away some of your upside potential if interest rates decline significantly.
Here is a table with the call dates for bonds in NPM:
NPM 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 89.28, so the call risk is minimal unless interest rates drop dramatically. I am not concerned about the falling interest rate scenario, since NPM would be highly profitable if this occurs.
Factor #10: For a National Fund, What Is the Breakdown by State?
Here is a breakdown by state for the NPM portfolio (top 5)
When you first look at this table, a red flag goes up because of the high concentration of bonds from Florida. But there is a good explanation for this. NPM recently acquired two other Florida closed-end funds. Here is a quote from the last management report:
In October 2009, just prior to the start of this reporting period, the Nuveen Florida Investment Quality Municipal Fund (NQF) and the Nuveen Florida Quality Income Municipal Fund (NUF) were reorganized into NPM. In general, the securities acquired through this reorganization matched the investment parameters and strategies of NPM and required little immediate portfolio activity. However, NPM’s exposure to Florida bonds rose significantly. During this period, we worked to reduce this exposure, when appropriate. As of October 31, 2010, NPM’s allocation to Florida bonds represented 31.3% of its portfolio, down from 36.7% twelve months earlier. We intend to further reduce NPM’s Florida exposure over time as appropriate opportunities arise.
I looked at the latest NPM portfolio and saw quite a few bonds with call dates in 2011 that will most likely be called within the next year. I expect the Florida percent ownership of bonds in NPM to drop steadily over the next few years.
One state I like to look for is Illinois, and I do not like to see the Illinois percentage exceed 10%, unless these bonds are very highly rated (AA or better) and for critical services like the water supply for Chicago. The Illinois percentage for NPM is well below 10%.
Factor #11: How Good Is the Trading Liquidity?
NPM has an average daily volume of 160,000 shares, and an average dollar volume of $2.2 million. I usually like to buy closed-end funds in chunks of $25,000 and do not like to be more than 10% of the daily dollar volume. NPM qualifies easily, since you can buy $200,000 in one day which is less than 10% of the daily trading volume.
Factor #12: What Percent of the Portfolio Is in Housing-Multifamily Bonds?
Given the shaky housing market, I like to avoid funds where the Housing Multi-Family sector is above 10%. NPM does not have any bonds in this category.
Factor #13: Fund Management
NPM is managed by Paul Brennan who has twenty years of experience, and joined Nuveen in 1997. He is a CPA and has also earned the CFA designation.
Factor #14: Other Analyst Coverage
NPM is covered by the Merrill Lynch closed-end fund team and is rated as a Buy.
Based on the above 14 factors, I believe that NPM is a solid core holding for most portfolios, especially when the discount to NAV is 5% or greater.
Disclosure: Author long NPM