The purpose of this article is to evaluate the Nuveen AMT-Free Quality Municipal Income Fund (NEA) as an investment option at its current market price. NEA is a CEF investing in municipal (muni) debt without a single state focus, as with many alternative funds. Rather, it holds bonds from multiple states, across the U.S. This provides investors with a reasonable level of diversification and could be more appropriate for investors residing outside of high-tax jurisdictions like California or New York.
I continue to advocate for muni debt exposure for a few reasons. One, despite the SALT deduction cap story being well-known at this point, investors with above-average incomes continue to hunt for places to earn tax-free income. With tax laws unlikely to change before 2021, this trade momentum should continue for the foreseeable future. Two, municipal bond issuance remains muted nationwide. While 2019 has seen an increase compared to last year, issuance levels are well below 2015-2017 levels on a year-to-date basis. This lack of supply is helping to support higher asset prices within the sector. Three, with interest rates heading lower, investors will continue to look for above-average income streams. Once tax benefits are factored in, funds like NEA offer after-tax yields that are very attractive.
First, a little about NEA. It is a closed-end fund with an objective "to provide current income exempt from regular federal income tax and the alternative minimum tax applicable to individuals, by investing in an actively managed portfolio of tax-exempt municipal securities". Currently, the fund trades at $14.32/share and pays a monthly distribution of $.0535/share, which translates to an annual yield of 4.48%. This is my first review of NEA and has come about because I wanted to highlight a CEF muni fund that trades at a discounted price, after recently recommending a similar fund from PIMCO at a premium valuation. For those investors turned off by the expensive price, I wanted to present an alternative option that is more value-focused. Similarly, I also regularly write about muni funds with a New York and California focus, and wanted to give an option for residents outside those two jurisdictions. Therefore, NEA has been on my radar for some time, and I will explain why I feel this could make a core muni debt holding for investors in detail below.
Macro Look: Supply Remains Tight
To start with, I want to first discuss why I believe the muni debt sector is an attractive investment space right now, before I drill down into NEA specifically. The primary reason for buying muni debt is for the tax advantages, which became highlighted in the 2017 tax reform when the SALT deduction limit was capped at $10,000. While this provision has been in place for some time, some investors were slow to jump into this sector following the reform. Furthermore, muni debt prices dropped immediately following the reform, due to decreased interest from corporate buyers, who now benefit from lower overall tax rates (and thus would save less from tax-free income). Once the full impact of this provision became felt after tax season, many Americans, especially those in high-tax states, have been consistently adding their exposure to this asset class to shield an income stream from state and federal tax.
In this backdrop, one can understand why the sector is performing well. In fact, interest in muni debt has helped NEA register a share price gain of almost 15% since 2019 began, and that return does not include the distributions paid. Clearly, momentum is on the side of muni debt, but that begs the question: Can this type of return continue going forward?
While we cannot know for sure how muni debt will perform heading into 2020, my opinion here is that price gains will continue, despite strong performance this year already. While I expect demand to remain consistent through the end of 2020, there is another part of the equation that is helping drive price gains: supply. While demand has soared, supply has been muted over the past two years, which is driving prices higher across the sector. According to data compiled by the Wall Street Journal, nation-wide issuance of muni bonds has been down significantly in 2018 and 2019, compared to the three preceding years on a year-to-date basis, shown below:
(Source: Wall Street Journal)
As you can see, issuance has seen a marked drop across the country and in California, a state with one of the largest muni debt markets. This reality, coupled with rising demand, has fueled a surge in prices. Fortunately, this is a trend I see continuing, as another part of the tax reform included the limiting of advanced refunding muni bond issuance, which municipalities used to issuance new bonds before the old ones had matured. This limitation has kept a lid on new issuance and, similar to the demand story, is something that is not likely to change until after the 2020 election. Therefore, this remains a long-term story and could even continue for the next six years if President Trump wins re-election and/or Republicans hold on to the Senate or win the House. If those scenarios occur, tax reform adjusting these important provisions is unlikely, and muni debt will remain a profitable place to invest.
Valuation Is Attractive
Now that I have highlighted my primary reasons for buying muni debt right now, I want to touch on why I think NEA is a solid choice for this exposure. A principal reason has to do with the fund's valuation, which is attractive on the surface and markedly cheaper than the PIMCO alternatives that I regularly review. Despite NEA's strong gains this year, the fund still trades at a discounted price just under double digits, as shown in the chart below:
|Current Discount||1-Year Valuation High||1-Year Valuation Low|| |
Average 1-Year Discount (at month-end)
As you can see, NEA has a history of trading at a discounted price, and its current level is no different. In fairness, NEA is actually more expensive than its 1-year average, by almost 3%, and the fund's valuation is sitting just below its 1-year high. However, the 9% discount is isolation is still an attractive figure on the surface, and should help to limit any potential downside because the share price is trading well below the underlying value of the fund.
Part of the reason for my optimism on this point has to do with the fund's NAV gains over time. While I mentioned the share price is up almost 15% this year alone, NEA's valuation is not higher, because the fund's underlying value has been rising consistently as well. In fact, it has seen its NAV increase by over 7% since last August, as shown below:
|Current NAV||NAV on 8/31/18||YOY Gain|
Clearly, this is a strong gain, especially considering the fund is delivering an income stream over 4% at the same time. This 7% gain has helped limit NEA's discount from narrowing further, and is supporting the share price action. This development is being driven by the supply/demand imbalance that I discussed in the preceding paragraph. Because I believe that the macro-outlook for muni debt will remain intact in the short term, I believe the gains to the fund's NAV will also continue going forward.
Illinois Has Seen Short-Term Progress
A second point on NEA has to do with the fund's underlying holdings. Specifically, the jurisdictions where it holds the bonds. To get a sense of how the fund will hold up going forward, I want to examine the financial picture of the state that makes up the largest individual weighting within NEA's portfolio, which is Illinois, as shown below:
Clearly, Illinois' overall financial health is going to drive performance for NEA, so it is important to discuss recent developments within the state.
Fortunately, this is a state that has seen some improvement in the short term, which is a positive for the fund. When looking back, Illinois is a state I would tend to avoid for muni exposure, because the state is saddled with extremely large pension obligations and continues to be one of the few across the country that does not have an "A" credit rating from either Fitch Ratings or Moody's, as shown below:
(Source: RBC Wealth Management)
As you can see, the investment community is a little bit cautious on Illinois in terms of credit rating.
With this mindset, why am I recommending NEA, whose top state is Illinois? The reason is because there have been some positive developments at a state level. For example, last month, Fitch Ratings affirmed the state’s BBB rating, which some investors believed was at risk of a downgrade. Further, its future outlook was revised to stable from negative, which was due to multiple developments. According to Fitch Ratings, the state of Illinois benefited from a revenue surge in April, which allowed the legislature to resolve a 2019 budget gap, as well as deliver a 2020 budget on time. Due to the potential for a higher revenue stream next year as well, Fitch Ratings stated, "the potential for a rating downgrade in the near-term has receded", which is certainly a positive sign.
Finally, as reported by Reuters, this past May, the Illinois House of Representatives approved a proposal to put changes to the state’s personal income tax system up for a public vote. This action had already passed the Senate, so it is going to be on the November 2020 ballot. At issue is a graduated individual income tax, which will progressively raise taxes on higher earners. The measure is expected to raise over $3 billion annually, if passed by the public, and could be used to improve the state's fiscal position. Currently, the state has a flat rate income tax, so this measure would be a dramatic shift in Illinois but with positive impacts for municipal bond holders.
What's The Risk?
Of course, investing in NEA is not without risk. The primary risk, in my view, is changes to the tax code, such as lowering corporate tax rates or raising the SALT deduction threshold to previous levels. These measures would impact muni debt in two ways. If corporate tax rates decline further, a similar scenario would play out that we saw in 2017 and 2018 with respect to muni debt. The after-tax savings of these investment vehicles would diminish for corporations, so institutional demand would continue to drop. On the other hand, a lowering of individual tax rates, or a raising of the SALT deduction limit, would also stifle muni demand. If wealthier individuals can go back to claiming unlimited state and local deductions on their federal tax returns, the attractiveness of munis would likewise decline. However, as I mentioned above, I don't think either of these scenarios is likely in the short term. With a divided Congress and a 2020 Presidential election looming, further tax reform is a very distant possibility. I would expect little to no new tax legislation over the next year and a half, and that reality should provide a tailwind for muni debt.
A second risk would be interest rate risk. Currently, the interest rate outlook is providing a tailwind for fixed-income assets of all types, including muni debt. With the Federal Reserve lowering interest rates last month, many investors began to rotate back in to fixed-income assets in order to lock in higher yields before they declined. Additionally, investors are anticipating additional cuts by year-end. According to data compiled by CME Group, market sentiment suggests at least two more cuts by the end of December, with three cuts being a very real possibility, as shown in the graph below:
(Source: CME Group)
This dovish outlook is helping to fuel a surge in demand for fixed-income assets, and helps explain the continued rise in funds like NEA.
The risk, however, is that this outlook is extremely dovish and may not match reality by the time 2019 is done. If the Fed does not end up cutting rates as much as the market thinks, fixed-income as an asset class could correct to the downside. NEA, along with most of the muni debt market, has seen such strong share prices gains that a correction could certainly occur if rate expectations are not met. And there is a very real chance of this occurring. Specifically, the market and Fed Chairman Powell seem to be having a disconnect between their two outlooks. While the market expects additional cuts, Mr. Powell stated the July cut should be viewed as a "mid-cycle adjustment". When pressed on the meaning of this verbiage in a press briefing, he stated:
Well, the sense of that is, I mean that refers back to other times when the FOMC has cut rates in the middle of a cycle. I’m contrasting it there with the beginning, for example, the beginning of a lengthy cutting cycle.
(Source: Federal Reserve)
My takeaway here is that the Fed is clearly keeping all options on the table, which means no further easing action is a very real possibility. If the Fed decides to keep rates at neutral levels through the end of the year (or raise rates, which I view as a very remote possibility), funds like NEA would see a bit of a correction. However, even if this does occur, I view the supply/demand story as having a bigger impact on NEA, which means my outlook would remain fairly optimistic.
Muni debt has been a profitable play in 2019, and I believe the story is not worn out yet. New bond issuance is low, and the current tax law will continue to support high demand for the existing bonds. This reality has been driving prices higher, and I believe that will continue over the next 12-18 months, which means investors still have time to get in. NEA is a reasonable way to play this trend, and with a discounted price and multi-state exposure, downside looks limited from here. Investors can capture tax-free income from a fund that is also AMT-free, which helps set NEA apart from a crowded field of muni CEFs. Therefore, I view the fund as a solid option for investors considering muni debt, and would encourage a serious look at this fund at this time.
Disclosure: I am/we are long PMF. 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.