Sell This Muni Closed End Fund While You Can

| About: Nuveen Enhanced (NEV)

Summary

Another closed end fund at extreme valuations.

А Z-score close to 4 makes it one of the most overvalued funds statistically.

If you are lucky enough to have it in your portfolio it is time to replace this holding with a better one.

This is the second article that suggests you should sell a specific closed end fund. As I am looking at my database I think I can write around 200 articles like this, but I will only pick out the best examples.

The majority of fixed income closed end funds are trading with a Z-score higher than 1. The hunt for yield in this extremely low yield environment, in addition to the low float of most of these funds, is probably the best explanation for this phenomenon. While these valuations may seem normal to some readers, you should never forget that the coin has two sides.

Closed end funds deviate around their average premium/discount level. And once you are buying or holding a closed end fund with a Z-score of 4, you are exposed to something I call "sentiment risk". Once the hunting season for yield is closed you may see any particular fund trading at (-2) standard deviations. This may result in a capital loss of 6 standard deviations without any change in the net asset value of the fund. If these numbers speak nothing at this point I will try to illustrate further in the article.

The fund

Nuveen Enhanced Municipal Value Fund of Beneficial Interest (NEV).

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Source: Nuveen

When buying NEV you are actually buying a municipal bond basket with a nominal yield of 5.54% (excluding zero coupon bonds) which trades 12 % higher than face value. This seems fine, but let's see the call structure of the portfolio:

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More than 50% of the securities are callable in the next 5 years. I presume the U.S. financial system is smart enough to refinance itself at lower market rates. Even though the callable securities are not guaranteed to be called, my personal expectation is that they will, because it is financially logical.

Now let's make a simple calculation. Let's assume that the average call date of the bond basket NEV holds is 8 years from now. I just chose 8 years, but every reader can make his/her own calculations in the link provided:

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The average yield to call in my example is 3.774% at the current price of $1120. I personally doubt that the yield of the underlying bond basket is as high as this so I will use this as the most an investor can receive from this basket.

You are paying around 1% annual expenses and have the benefit of leverage at 31% effective leverage ratio (with cost around 1%). Alternative financial thinking is a must in any investor's mind and I can certainly find logic in holding such a bond basket over some of the alternatives. It has a high credit quality and municipal bonds are triple tax exempt. Not that I will hunt a 3% yield for the next 8 years, but as a static investor who wants the best risk adjusted yield, there is no other place to find a better deal.

Why sell?

While there is financial logic in holding the bonds (especially for large institutions), why is the small investor rushing in to buy closed end funds like this? Why would anyone pay an extreme premium to hold such a basket of bonds? We don't need to panic; we will always be able to find yield somewhere.

Let's look at the example with the bond basket price, but now adding the 7% current premium:

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This is definitely not very impressive. Keep in mind that this is a positive scenario. There are probably a lot of bonds in the basket that have yields way lower than 2.72% and probably negative yielders that bring capital loss risk if being called.

The statistical check

NEV has rallied in the last weeks while MUB and the fund's NAV have not responded to this rally. This should be vice versa in general:

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Source: Author's software.

For me as a trader this is always an arbitrage opportunity, but lately hard to borrows are really expensive and the majority of these small inefficiencies are only worth switching once you own the fund. Let's dig further in why you should sell the fund:

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As we can see the fund is at its highest premium for the last 200 days. This is close to the all time extremes from 2012.

The regression model with MUB has been quite stable over the last 200 days, but recently the fund price has made a sharp deviation. This would be justified if the fund's NAV was doing the same, but it is not. The statistical inefficiency is clear to anyone interested in closed end funds.

Alternatives

The first alternative is to just buy MUB or any other municipal bond exchange traded fund that tracks its NAV way better than a closed end fund. This way you will be invested in a similar bond basket without overpaying a premium and a high management fee. You can then switch back to NEV once the statistical inefficiency is gone and the fund is trading closer to its average premium/discount levels. Another option is to switch to a less overvalued closed end fund that at least trades at a discount.

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This is a list of most deviated closed end funds that have a high correlation with NEV. NQM is a very similar fund to NEV, and statistically it is the better choice at the time of writing the article.

This can easily be seen on the below chart. It constructs two portfolios from the two funds adjusting their dollar values so that they have a beta coefficient of 1, and it is irrelevant for the investor which fund he/she holds statistically. In this situation you have to switch from one to another on any large deviation:

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This can also be used as a pair trade, but calculations there must be way more accurate, plus a low hard to borrow rate and availability in shares to short is a must.

Conclusion

NEV is another good example of a low floater that can not handle the buying pressure. I am starting a series of articles that will concentrate on such statistical inefficiencies. You can leave comments with advice on what to include in the articles, because my main point of view is the statistical deviation from average premium/discount levels. I find this is enough to make a decision, but every investor has different goals and methods.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.