NXR: A Good, Unleveraged Muni Bond CEF

Mar.14.11 | About: Nuveen Select (NXR)

This is one of a series of articles on specific municipal bond closed-end funds. In this report, I will analyze the Nuveen Select Tax Free Income 3 Fund (NYSE:NXR). NXR is national unleveraged municipal bond closed-end fund that is currently earning a tax free yield of 5.02% with no return of capital.

NXR is a national fund that primarily invests in long-term investment quality tax free municipal bond holdings.

I will be discussing 14 factors you can consider when evaluating any municipal bond closed-end fund. For more background information on these factors, refer to my first report on NPM.

Factor #1: What is the distribution rate?

In the current market, there are three “tiers” of national municipal 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.

NXR falls in the safer, low volatility tier and currently has a distribution yield of 5.02%. It pays a regular monthly dividend of $0.0535 per share or an annual distribution of $0.642.

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 NXR, the average earnings over the last three months are $0.0553, which is higher than the recently increased monthly payment. The average earnings/current dividend ratio is now 103.4%.

I 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 NXR, the UNII per share is +0.0142 which provides a small cushion to protect the monthly dividend payout.

Factor #3: What is the expense ratio?

I look at the Baseline expense ratio which does not include leverage costs. NXR has a baseline expense ratio of 0.36% which is well below average. This factor is a big plus for NXR.

Factor #4: What is the discount to NAV?

NXR is currently selling at a -5.33% discount to NAV which is significantly better than the 6 month average discount of -0.58%. The one year Z-statistic is -1.78, or nearly two standard deviations below the average discount. Overall, this factor is a definite positive for NXR.

Factor #5: How much leverage is used, and what is the preferred share asset coverage?

NXR is unleveraged.

Factor #6: What is the AMT exposure?

NXR has an AMT percentage of 5.35%. This is well below average, so this factor is a positive for NXR.

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 NXR:

AAA

35.39%

24.79% US guaranteed

AA

27.89%

A

21.14%

BBB

12.88%

BB & Below

2.7%

Includes unrated.

Click to enlarge

NXR is a solid fund with an average credit rating around AA. I like to see the lowest rating category (BB & Below) less than 10%, and NXR qualifies easily.

Factor #8: What is the interest rate exposure?

NXR has an average modified duration of 4.96. This is well below average for municipal bond closed-end funds, partially because NXR does not use leverage. If interest rates go up by 100 basis points or 1%, the net asset value of NXR would drop in price by about 5%. I view this factor as a positive in the current interest rate environment.

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 upcoming call dates for bonds in the NXR portfolio:

Non- Callable

8.8%

2011

18.8%

2012

24.8%

2013

20.2%

2014

7.5%

2015

4.5%

Click to enlarge

Looking just at the upcoming call dates, NXR appears to have significant call risk over the next three years, but the average bond price is only 83.62, so the call risk seems to be minimal.

Factor #10: For a national fund, what is the breakdown by state?

Here is a breakdown by state for the NXR portfolio (top 5):

Illinois

18.83%

California

10.13%

Texas

10.03%

Colorado

6.91%

Indiana

6.15%

Click to enlarge

The high percentage allocation to Illinois is at first a red flag. But there are several reasons why I am comfortable with the Illinois holdings in the NXR portfolio. First of all, I have a great deal of respect for the portfolio manager, Thomas Spaulding.

I also drilled down to look at the Illinois holdings in more detail. Two of the holdings are pre-refunded and backed by the US government. Most of the other Illinois holdings are rated AA or better and look solid.

For example, one large $6 million holding is a AAA revenue bond backed by the Metropolitan Pier and Exposition Authority (McCormick Place Expansion Project- NPFG Insured). Another large Aa1 holding is backed by the Illinois Health Facilities Authority (University of Chicago Project).

Of the $34 million invested in Illinois bonds, I only found one $2 million holding rated less than A, and that was a Baa1-rated bond (Illinois Health Facilities Authority, Elmhurst Memorial Healthcare).

Factor #11: How good is the trading liquidity?

NXR has an average three month daily volume of 41,000 shares, and an average dollar volume of $500,000. 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. NXR has reasonable liquidity, since you can buy $50,000 in one day and be about 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 Housing sector bond holdings are above 10%. NXR has only 1.54% of the portfolio in this sector.

Factor #13: Fund Management

NXR is managed by Thomas Spaulding. He joined Nuveen in 1975 and is an authority on the subject of municipal bonds and bond fund investing. He received his undergraduate degree and MBA from the University of Michigan and has earned the CFA designation.

Factor #14: Other Analyst Coverage

NXR is covered by the Merrill Lynch closed-end fund team and is currently rated as a Buy.

Based on the above 14 factors, I believe that NXR is a good core holding for investors that are uncomfortable with leverage and are longing for a good lower volatility fund. NXR has often sold at a premium over net asset value, but is currently available at a discount to NAV.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.