Reviewing The Latest UNII/Coverage Of BlackRock And Nuveen CEFs

Summary

• We go through Nuveen taxable and muni CEFs looking at coverage ratios, UNIIs, and trends.
• These monthly reports can provide valuable insight into whether or not a distribution is safe or not. More importantly, why a fund may trade cheap or rich.
• We look at some of our favorite names in each category and give readers some insight into our thinking.
• Please note that we have specific "buy under," "sell over" thresholds for our members to follow with real-time ratings to guide them.
• We provide an article update at the end.
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(This report was published on April 29 to members of Yield Hunting. All data herein is from that date except the commentary in the update near the end.)

Both BlackRock and Nuveen have reported their UNII and coverage data for March. The data is a bit different as the Nuveen muni CEFs showed significant declines in coverage as they likely had to delever from the spike in SIFMA funding costs. BlackRock didn't show those same kinds of declines to coverage although some funds did drop more than typical.

For reference on Nuveen, please see "Municipal CEF Distribution Cuts Coming" as it goes through the issue of Nuveen muni CEFs. We wrote:

In all likelihood, Nuveen was a forced seller at bad prices. Why were they forced to sell? The SIFMA Muni Swap Index which is essentially their benchmark for borrowing to apply leverage, spiked in March as liquidity dried up. It hit 5.12% on March 23rd, the highest since the 7.96% reached in September 2008 shortly after Lehman failed.

Since then, the SIFMA index has plummeted which allowed them to not have to be forced sellers and even raise distributions.

We go through each section of the UNII reports, taxable and tax-free, among the two largest sponsors of closed-end funds.

Nuveen Taxable Bond CEFs Analysis

The Nuveen taxables showed nice improvement in the month of March with floating rate moving coverage up nicely. The S&P 500 LSTA Leveraged Loan average price rose to $86, from the low $70s, at the depths of the market turmoil helping boost NAVs. But that has no effect on coverage ratios. We likely have seen significant reductions in funding costs which would have had a positive effect on coverage. Also, spreads widened dramatically in March, allowing for the addition of much higher yielding positions into the portfolio, helping to boost net investment income.

(Source: Alpha Gen Capital)

In Nuveen preferreds, we saw a significant improvement in coverage during March for three of the four funds - Nuveen Preferred Securities Income (JPS), Nuveen Preferred Income Opps (JPC), Nuveen Preferred and Income Term (JPI) - with Nuveen Preferred and Income 2022 Term (JPT) the only fund showing reduced coverage. The decline in coverage for JPT was very small and not a concern to me. The four funds are largely correlated though run by the same people with the same positions. The preferred space in general is a bit expensive which is why I favor JPT and its term structure to prevent the discount from blowing out.

And in some of the other sectors, coverage ratios were down slightly. The fund in this group that we are mostly concerned about is Nuveen Taxable Muni Income (NBB), which cut in October of last year. NBB uses tender options bonds ("TOBs") that we discussed in the "Muni Cuts" article referenced above with $156M outstanding out of a total of $334.8M in total leverage. The rest comes from reverse repos ($178M), which helps offset some of that risk given the flexibility of that type of leverage. Call exposure is 8.2% for the next 12 months with mostly investment grade credit. I like NBB if you can buy it at a nice discount of at least -4% to nibble and back up the truck if it got to -6% or -7%.

(Source: Alpha Gen Capital)

Nuveen Municipal Bonds Analysis

Munis have been hit in the last two weeks as investors worry about municipal/public finances. As states deal with coronavirus when their economies shut down, budget deficits are going to blow out. Looking at the federal deficit, we are now seeing spending as a percentage of GDP at levels of World War II.

Governments are just starting to feel the first pangs of the financial crunch and the fear is that the rate of delinquencies is going to rise substantially amid high unemployment rates.

Last week, Senate Majority Leader Mitch McConnell said he supported letting states declare bankruptcy which began the more pronounced slide in the muni space that we are seeing today. Current law currently prohibits bankruptcy for states.

We will be doing another muni update in the next ten days after we receive the distribution notices on the first of the month.

(Source: Alpha Gen Capital)

UNII levels are the best indicator of distribution stability. One of the reasons why I like Nuveen AMT-Free Quality (NEA) is that the UNII level is positive (barely) but also rising. Compare that to other large national muni CEFs like Nuveen Muni Credit Income (NZF) and Nuveen AMT-Free Muni Credit Income (NVG) which have sizable, negative UNII levels. For similar yields, why not go with the safer bet?

(Source: Alpha Gen Capital)

The weakest distributions among this group are but even these funds are not that vulnerable:

1. Nuveen Municipal Credit Income (NZF)
2. Nuveen AMT-Free Municipal Credit Income (NYSE:NVG)
3. Nuveen AMT-Free Municipal Value (NUW)
4. Nuveen Municipal Income (NMI)

I think NEA and NAD are very safe from a distribution cut though nothing is for certain given the volatility in the markets and coverage ratios below 100%. Leverage costs are way down with the SIFMA falling another 15 bps last week to just 0.21%. This is a net tailwind to muni CEFs supporting NET investment income. NEA is currently only covered by 96.6%, which is down significantly from the month prior.

Nuveen Muni High Income (NMZ) saw its UNII decline for the fourth straight month though it remains well above zero. The distribution appears safe to me at this point and the current discount is over -3%, a place it rarely has been in the last two years (update: This fund is back to a small ~2% premium since this writing.)

Munis, generally speaking, have been very poor performers in the last several weeks as headline risk hurts the sector. There have been only a handful of opportunities to get into the muni market at the most opportune times in the last 15 years: Meredith Whitney (2010-2011), Taper Tantrum (2013), rate rise scare (Q4 2018). This is setting up to be one of those times. Each time was a direct result of either a fear of rising rates or credit defaults. This is clearly the latter as rising rates isn't much of a concern - at least for the next year.

Since the start of March, the Bloomberg Barclays Municipal Index (TFI) is down just over 3%. It had been down far more in the middle of March but recovered about 60% of the decline.

Data by YCharts

The decline in muni CEF NAVs has been two fold: 1) Liquidity discount and 2) credit risk. The liquidity risk issue has largely been rectified as the Fed has stepped into the market. All that is left, in my opinion, is primarily credit risk or the risk of defaults on municipalities.

NMZ and NEA are the two best opportunities from Nuveen though neither one of those has the most compelling fundamentals of rising UNII and rising coverage. However, both are trading at attractive discounts that overcome some of their failings.

BlackRock Taxables Analysis

One of the most common questions we get is about the low coverage among the taxable bond CEFs from BlackRock. Remember that Saba, an activist hedge fund, was attacking a few of these funds so BlackRock decided to institute what is essentially managed distribution policies ("MDP") raising the distribution by approximately 25% across the board. That's why coverage ratios are generally in the 75%-85% range.

(Source: Alpha Gen Capital)

More pertinent is the valuation and NAV trends. So let's go through them in the next few charts. First up are the three floating rate funds. Each has a low 80% coverage ratio and relatively flat UNII level. More importantly, the NAVs are still down between 13% (BGT) and 14.4% (DSU) with (FRA) in between from the peak. Prices are down about 5%-7% more than NAV as discounts widened out.

Data by YCharts

Here are what the discounts have done since the peak in mid-February with funds going from ~8% to ~13%-14% over that time frame.

Data by YCharts

As we noted above in the Nuveen Taxables section, the leveraged loan price is now at $86-$87. If it were to rise back to $97-$99, where it was, the majority of the NAV loss (the -13%-14%) would likely be recovered. Still, with many resets still coming, distributions are likely in some degree of peril. A reset is the floating aspect of the loan. With rates down, the yield on the underlying bonds will be reduced, reducing net investment income and likely leading to distribution cuts.

In high yield, we have Corporate High Yield (HYT), Limited Duration Income (BLW), and MultiSector Income (BIT). NAVs are down similar levels compared to floating rate, which makes sense. The high-yield index price is now back over $88, compared to $98 prior to the downturn. Again, most of the NAV loss would be recovered if that price were to move back to where it was previously.

Data by YCharts

Discounts have widened out but not nearly as much as we've seen in the floating rate space. Discounts are still generally wide at -10% to -11% from approximately -4% before the crisis.

Data by YCharts

Investment grade has a wide range of performance dispersion with BlackRock Income Trust (BKT), a very safe agency MBS fund seeing very little volatility while others with mixes of junkier bonds in it like BlackRock Credit Allocation (BTZ) showing more volatility.

Data by YCharts

Discounts are much tighter compared to the other sectors above. However, they were not immune to the downturn as BTZ and BHK reached mid-teen discounts during the worst of the turmoil. Today, the discounts are relatively tight compared to other sectors as investors pile into safety.

Data by YCharts

We still like BlackRock Credit Allocation among this group as it provides a great long-term track record, juicy yield (though not covered), and nice discount to NAV. Just in the last few days the discount has widened to nearly 10% with over an 8% distribution yield.

For those who are highly risk averse, BKT remains a viable option, just know that the upside you are likely to realize is very limited. BBN, a taxable muni fund, is a great "in between" option that offers up a little more upside potential. For those that are risk tolerant, I like the floaters here, especially BlackRock Floating Rate Strategies (FRA).

BlackRock Municipal Bond CEF Analysis

Overall, BlackRock's muni funds look much better than Nuveen - something I have always said generally speaking about the two sponsors for years.

BlackRock doesn't really let the UNII level go negative so most were able to weather the storm by tapping reserves.

Given the recent virus dislocation, we have to assume that the portfolio managers have been busy making changes to the portfolios based on their assessment of default exposure and Fed backstopping. Reported numbers are through March 31, one has to assume there have been even more changes in April.

We have six national muni conviction funds:

• BlackRock Municipal Bond (BBK)
• BlackRock MuniYield Quality II (MQT)
• BlackRock Invest Quality (BKN)
• BlackRock MuniYield Quality (MQY)
• BlackRock MuniEnhanced (MEN)
• BlackRock MuniHoldings II (MUH)

There really are no concerns with the first 4. They all score in the top six using our methodology which values yield, discount, coverage, UNII balance and trend, and estimated two-year redemption exposure. (The other two top finishers are BlackRock Municipal Target 2030 (BTT) with a low 3.3% yield and BlackRock Municipal Income (BFK) which we've avoided due to the 12% call exposure in the next year).

Scoring much lower is MEN which took a big hit to coverage in March, however one could argue to retain it given its low redemption exposure and wide discount. Also, UNII barely moved since coverage was still over 100%.

MUH should be retained because of high yield and super high UNII balance.

Same as last month, based on this scoring, my next BlackRock muni dollar would go to BBK: strong coverage and UNII, high yield and wide discount.

No other National funds with decent point totals are worth adding, either because of a lack of UNII or excessive redemption exposure.

Overall, distribution sustainability of all six funds looks solid and it would be a surprise (something we don't see) that causes them to cut the distribution on May 1. (Update: No cuts.)

We don't post our scoring methodology but essentially it looks at several factors including UNII balances, trends, coverage, redemption exposures, if they had a recent distribution cut, etc.

Below is the UNII balances and changes for the last three months. Again, BlackRock doesn't typically let its balances get too negative preferring to adjust more often than say a PIMCO.

Looking just at UNII levels and changes, a few funds are at a high risk of cutting on May 1 including:

• BlackRock MuniYield Investment (MYF)
• BlackRock MuniHoldings (MHD)
• BlackRock MuniYield Fund (MYD)

(Note: all % changes are positive even in the cases of negative balances becoming more negative for the sake of comparison.)

(Source: Alpha Gen Capital)

Here are the coverage levels and the changes over the last couple of months:

(Source: Alpha Gen Capital)

The state specific BlackRocks - BlackRock MuniHoldings NJ Quality (MUJ), BlackRock NY Muni Income II (BFY), BlackRock NY Muni Income (BNY)- saw similar declines in coverage. MUJ saw the largest drop with the coverage. UNII remains comfortably positive at +6 cents. I'm still holding that position and the large discount (over -16%) makes me think the market is expecting a distribution cut in some of the weaker states fiscally and who have been hit harder by the virus - which is certainly NJ.

BNY also took a hit in coverage falling to 95% with UNII at 7.6 cents. While coverage is below 100%, the fund has significant reserves to tap before it would need to cut the distribution. This one should be safe to continue holding. Compared to BFY, this one has a lower yield, lower fundamentals (though still good) and less of a discount.

BFY saw coverage decline as well but remains nicely above 100% at 102.3%. UNII is a massive 9.7 cents now. The discount is nearly -15% and the yield approaching 5%. Like MUJ, there is some '"credit" risk being assumed here as investors sell the harder-hit states, but I do think this fund and its large amount of AA-rated debt should be OK for now. The top holdings include a lot of convention center and transportation bonds - bonds that previously were as safe as Fort Knox but now looked upon as weak. We favor it over BNY.

Concluding Thoughts

The month of March had a lot of moving parts and some significant deleveraging in the tender option bonds among all munis. We looked at the two largest sponsors of muni CEFs here, Nuveen and BlackRock, and the two had different outcomes perhaps suggesting a different strategy in dealing with the market turmoil. We continue to favor BlackRock munis over Nuveen (and PIMCO for that matter) and think they have been better at managing the portfolios for risk.

Top buys would be:

• BlackRock Municipal Bond (BBK)
• BlackRock MuniYield Quality II (MQT)
• BlackRock Invest Quality (BKN)

Article Update

We did not see any distribution cuts in the muni CEFs at BlackRock or Nuveen. In fact, Nuveen made no cuts across their entire CEF complex and BlackRock only cut in their equity funds.

Both Nuveen and BlackRock were able to skirt the SIFMA spike (higher leverage costs) by just holding tight and allowing the market to rectify rather than sell down. This turned out to be the right move.

At the same time they were able to significantly lower leverage costs when the SIFMA index plummeted in April. At the same time, they conducted bond swaps: Essentially selling munis that didn't fall much in price and buying much higher coupon bonds in beaten down segments of the muni space, for instance, airports, toll roads, healthcare facility, redevelopment bonds, etc.

Those two events along with not doing any forced selling in March allowed them increase net investment income production in April. This led to an increase of distributions for May. For example:

• Nuveen Quality Muni Income (NAD): Distribution increased by 6.5% to $0.057 from $0.0535
• Nuveen AMT-Free Quality Muni (NEA): Distribution increased by 5.61% to $0.0565 from $0.0535.
• Nuveen Muni High Income Opp (NMZ): Distribution increased by 4.2% to $0.062 from $0.0595

Analyst’s Disclosure: I am/we are long BBK, NEA. 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.