This is the second of a series (see first article here) of articles on specific municipal bond closed-end funds. I have selected a single-state municipal bond fund from New York. A similar analysis would apply to funds from other states.
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.
- 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 a customized national fund by selecting only the 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 will suffer. There is also less of a selection of issues to buy compared with a national fund.
For this report, I’ve selected the Nuveen New York Select Quality Municipal Fund (NVN). It is a leveraged fund with above average credit quality, average trading liquidity and low AMT percentage.
I will be discussing the same 14 factors that I use to evaluate other municipal bond closed-end funds. For more background information on these factors, refer to my first report on NPM.
Factor #1: What is the distribution rate?
Single-state municipal bond closed-end funds often have somewhat lower distribution rates than national funds because of the greater tax benefits. NVN is a high quality fund in the middle tier and currently has a distribution yield of 6.29%. It pays a regular monthly dividend of $0.070 per share or an annual distribution of $0.84. This does not include a special year-end dividend of $0.0292 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 NVN, the average earnings over the last three months $0.0681, so the Average Earnings/Current Dividend ratio= 97.3%. In the last Nuveen report from year-end 2010, this ratio varied from a low of 96.5% to a high of 107.6% for the New York municipal funds. But the New York funds with the higher percentages have much lower distribution yields in the 5% range.
Normally this factor would be a red flag for NVN. But there is a healthy positive value for “Undistributed Net Investment Income” or UNII of +0.1871, which means that NVN has more than two months monthly interest in reserve to cover the small monthly shortfall.
Factor #3: What is the Expense Ratio?
I look at the Baseline expense ratio which does not include leverage costs. NVN has a baseline expense ratio of 1.15% which is about average. Anything over 1.5% is a big negative.
Factor #4: What is the discount to NAV?
NVN is currently selling at a 4.98% discount to NAV which is slightly more than the 6 month average of 4.22%. But the one year Z statistic is +0.44. So on a one year basis, the discount is about half a standard deviation less than the usual discount. Overall, this factor is a very slight negative for NVN, but because the daily volatility of these funds can be quite large, it should be possible for a patient investor to buy NVN at a somewhat larger discount closer to 6%.
Factor #5: How much leverage is used, and what is the preferred share asset coverage?
NVN currently uses 39.37% effective leverage. The preferred asset coverage ratio is currently 304% which provides an adequate margin of safety. I would be concerned if this ratio dipped below 225%.
Factor #6: What is the AMT exposure?
NVN has an AMT percentage of 3.25%. This is well below average. I consider 10% AMT to be about average, and anything over 20% is high. This factor is a positive for NVN.
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 NVN:
BB & Below
NVN is a very solid fund with an average credit rating around AA-. I like to see the lowest rating category below 10%, and NVN qualifies easily.
Factor #8: What is the interest rate exposure?
NPM has an average duration of 11.68 years. This is about average, but I would prefer a somewhat lower duration below ten years.
Factor #9: What is the call exposure?
Here is a table with the call dates for bonds in NVN:
NVN would have significant 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 98.23, so there is only moderate call risk. I am currently more concerned about rising interest rates than falling rates.
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%.
Factor #11: How good is the trading liquidity?
NVN has an average daily volume of 38,000 shares, and an average dollar volume of $0.535 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. For a fund like NVN, I would normally cut down on trading size and buy in lots of 1,000 shares or less.
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%. NVN has only 1.95% in this category.
Factor #13: Fund Management
NVN is managed by Carolyn Steeves who joined Nuveen in 1997. She specializes in managing single-state municipal portfolios and has a PhD from Columbia.
Factor #14: Other Analyst Coverage
NVN 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 NVN is a good holding for high income NY state residents, when the discount to NAV is 6% or more.