This monthly Nuveen municipal closed-end fund UNII and earnings report is arguably the most anticipated and important in recent memory simply due to the fact that the market experienced some significant pain in the last 45 days. Discounts widened dramatically with coverage ratios falling. Most importantly, NAVs have rolled over significantly in conjunction with the iShares Municipal ETF (NYSEARCA:MUB) which hit its high in mid-July.
Interest rate fears are the main driver of the discount widening in the last few weeks. The Fed has essentially sent the market a memo stating their intention to raise rates this December. Sentiment has soured drastically since the middle of the year, very much like last year. On October 17th, despite interest rates falling back to the mid-1.7% area, these muni CEFs continued to sell off.
Muni's continue to underperform treasuries due to a large amount of supply that has come to the market. Couple that with a slowdown in fund flows (which we highlighted in our prior month's write up) means that rates will go up while prices fall. In a short period of time, muni CEFs gave up ALL of their year-to-date gains. Many of the holders of shares of muni CEFs are retail investors and tend to easily get spooked by higher rates. That accounts for the discount widening. But the lower NAVs are attributed to increased supply and higher interest rates generally with the ten-year rising to 1.80%, decreasing prices.
Below is a chart of the VanEck Vectors CEF Municipal ETF (NYSEARCA:XMPT) which is an ETF of muni CEFs:
(Source: Yahoo Finance)
Yields on new issues have plummeted with the MUB now generating an average yield of just 1.74%.
There has been a spike in new municipal supply which totaled $323.4 billion in the first three quarters of 2016, a 7.4% rise yoy. The third quarter supply totaled $110 billion, a massive 18.4% increase from the year before. August and September were especially high in supply exceeding their historical averages. Clearly a large amount of supply has hit the market, and this week looks no different with a large $15.5 billion of new issues. That rate of supply, as municipalities take advantage of the low rates to call and refinance issues, is likely to continue through the fourth quarter.
However, we think once that bulge in supply passes close to year-end, and the fears of the interest rate hike subside by the first quarter, the sentiment in the class should shift. Until then, the muni CEF market is likely to remain volatile with generally flat-to-falling NAVs and wider than average discounts.
Nuveen National Muni Update
Compared to our August update, Nuveen's national muni CEFs saw the average discount widen from -2.1% to -5.2%, a fairly significant one-month move. The average coverage ratio fell by 130 bps to 96.7%. However, the ramifications of the mergers between several smaller funds into very large one's have yet to be completed. Nuveen added this footnote to the monthly update:
|1Monthly earnings per share of the Nuveen Dividend Advantage Municipal Fund (NYSE:NAD) and the Nuveen AMT-Free Municipal Income Fund (NYSE:NEA) are an estimate of the current month's earnings, which does not represent a fully transitioned portfolio to the new enhanced credit mandate.|
The table below updates the 16 national muni funds.
(Source: Nuveen, Alpha Gen Capital)
NAD and NEA have seen significant discount widening since the merger. The two funds completed a distribution before the merger that reset their UNII balances back to zero as part of the 'agreement' with the target funds. They were also required to adjust the distribution of the acquiring fund to the highest rate among all the funds involved in the deal. This has possibly created an artificially high distribution rate.
The coverage ratios of the Nuveen Dividend Advantage Municipal Income Fund (NVG) and the Nuveen Dividend Advantage Municipal Fund 3 (NZF) (top 2 on the table above), which undertook mergers earlier this year in April, have seen increasing coverage over the last three months. In the face of increasing headwinds, the higher ratios are likely the product of the shakeout and convergence of portfolios with trading and positioning ongoing. It will likely take several months before we have a true picture of the current earnings coverage of NAD and NEA as we are just now seeing it for NVG and NZF.
While we think it will be above the low ratios being reported today of 88.1% and 87.1% for NAD and NEA, they will likely still be under-earning the distributions. Eventually, and it is unclear when at this point, the funds will in all probability have to cut their distribution payments.
The question is if the market is already anticipating a cut given the current discounts to NAV. NAD has seen a massive discount widening in the last month-and-a-half with the six-month z-score of negative 3! We will not know for certain about the longer-term health of the fund until they release financials in a few months.
The chart below shows the discount over the last year. The recent move from the tight spread realized in August, before the merger, widened out when the merger completion date was announced. That was coupled with the move in the market in general which exacerbated the decline.
We think the funds are incorporating a lot of pessimism into them currently. The wide double-digit discounts compared to the 2-3% discounts of August (just two months ago!) reflect both investor sentiment about the future path of interest rates, as well as higher yields due to the large amount of supply. While we have reached maximum pessimism which is typically the best opportunity to buy, we think a reversal in the NAV trends are needed before accumulating larger positions.
The muni CEF market had a fairly significant upheaval in the last month as the specter of higher interest rates scared many investors, requiring a larger discount on the shares. Meanwhile, higher ten-year yields on treasuries and supply/demand imbalances helped to push down prices of the underlying muni bonds, rolling over the NAVs. The bloodbath that has occurred could continue as we approach a seasonally weak part of the calendar and approach the FOMC meeting in December.
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Disclosure: I am/we are long NEA, NAD, NVG.
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