CEF Strategies: Another Valuation Headscratcher In Municipal Bond CEFs

| About: Nuveen AMT-Free (NEA)
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It sometimes boggles my mind how short sighted investors can be in the CEF space. The latest is in the Municipal bond CEF sector.

Certainly, interest rates and a host of other worries are starting to creep into the municipal bond markets once again, which means CEFs can get dramatically more volatile.

But when a few funds get thrown out for reasons other than interest rates while other CEFs continue to find support even at premium valuations, opportunity knocks.

I'm going to get this out quick so please pardon me if there are minor errors. The municipal bond market has been under pressure recently over the fears of rising interest rates and those fears can just be magnified in the CEF space because municipal bond CEFs generally use heavy doses of leverage. Combine that with less liquid securities like CEFs and these fund's market prices can go all over the map even if their NAVs barely move.

And what do you get with that added risk of leverage? You get higher yields. Most National municipal bond CEFs offer anywhere between 4.5% to 5.5% tax advantaged distributions which is dramatically higher than comparable municipal bond ETFs and mutual funds.

Muni bond CEFs have been one of the strongest fixed-income sectors over the last few years and from time to time, I like to throw in an article on the sector. This one, The Sad State Of Muni Bond CEFs, was at virtually the lows for the sector in late 2013.

I've been pretty good at calling inflection points in this sector and I'm going to make another one right now. This past April and just this last month in September, Nuveen closed on the mergers of four national municipal bond CEFs to create superfunds of between $3 billion to $6 billion in total managed assets each.

The four funds are the Nuveen Enhanced Municipal Credit Opportunities fund (NYSEMKT:NZF), the Nuveen AMT-Free Municipal Credit Opportunities fund (NYSEMKT:NVG), the Nuveen AMT-Free Quality Municipal Income fund (NYSE:NEA) and the Nuveen Enhanced Municipal Credit Opportunities fund (NYSE:NAD).

The genesis of the mergers was to create larger funds that could offer investors greater economies of scale in the form of liquidity and expenses mostly. Since Nuveen has so many municipal bond CEFs which may have been competing with eachother for new issues, etc. it made sense to take this step.

Most municipal bond CEFs are not that much different anyway. They all use similar levels of leverage (although some lower yielding funds don't use leverage at all), they all own many of the same issues and compete for any new issues coming to market. The minor differences between the funds have to do with credit quality, state weightings, average maturities and called-bond features. But frankly, these funds tend to move together very closely, not just at NAV but also at market price.

However, recently that has changed. I want to first show you a 1-year total return table of a cross section of National municipal bond CEFs sorted by their NAV total returns (boxed column).

The four Nuveen funds, NZF, NVG, NEA and NAD are highlighted in green and you can see that their NAV performances are well above average for the sector. So why do they trade at such wide discounts when many of these other funds trade at closer to par to even premiums?

In fact, NEA and NAD trade at the widest discounts of all muni bond CEFs and NZF and NVG are not far behind. Take a look at a 5-day market price graph of the four funds compared to the PIMCO Municipal Income fund II (NYSE:PMF), a fund that trades at a 24.7% market price premium!

Now, PIMCO is a great fixed-income manager and they probably deserve their premiums to a degree as they are often more aggressive than other fixed-income managers. But if there is some kind of concern about the impact of higher interest rates on the municipal bond market, it sure isn't being reflected in the PIMCO funds.

So why are the Nuveen funds getting hammered so much worse and being driven down to -8% to over -9% discounts, not that far from the worst valuations even back in late 2013 during the municipal bond debacles going on in Detroit and Puerto Rico?

Quite simply because institutional managers of the acquired funds that merged into NZF, NVG, NEA and NAD in April and then in September are probably taking advantage of the increased liquidity and are lowering their exposure. I can't think of any other reason. As a refresher, here are the funds that merged into NZF and NVG in April:

And here are the funds that merged into NZF and NAD just this past month:


I would take this opportunity to add some of these newly merged superfunds from Nuveen. Though I can't say where interest rates will go from here and you may need to average down, this is more a call on the wide valuation discrepancy that I believe gives an opportunity right now to tax-advantaged income investors.

Disclosure: I am/we are long NZF, NEA, NAD, NVG.

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.