NAD: Recent Sell-Off Looks Like A Buying Opportunity To Me

Summary

  • The muni market, including NAD, has been facing some weakness. I would use that as an opportunity to build to positions.
  • Duration risk in the sector is high, so rising inflation metrics do have me concerned about total return. This is why I would time my purchases very carefully.
  • Credit risk, especially in the investment grade realm, remains very limited. Municipal tax receipts recovered quickly since the first half of 2020, and I see minimal defaults going forward.
  • The calls for higher tax rates remain an important tailwind, although there are other legislative actions that could mitigate this impact.
  • This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

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Main Thesis / Background

The purpose of this article is to evaluate the Nuveen Quality Municipal Income Fund (NYSE:NAD) as an investment option at its current market price. This is a multi-state, closed-end fund with an objective "to provide current income exempt from regular federal income tax and to enhance portfolio value." I have owned NAD for a while, moving into it over the past year to supplement my pre-existing muni holdings. While I have mentioned it in prior reviews, this is my first article specific to the fund in isolation. I feel it is timely to cover it now because the fund has seen a bit of a sell-off lately, which is consistent with the broader muni market. In fact, it has dropped about 5% in the last month alone, as shown below:

Source: Seeking Alpha

With this in mind, I wanted to take a more extensive look at NAD to see if I should become more cautious, or use this drop as a buying opportunity. Personally, I see some value here, and plan on adding to my stake in the current weeks ahead for a number of reasons, which I will explain in detail below.

Valuations For Muni CEFs Have Come Down

To begin, I want to touch on a key reason why I am less hesitant to buy NAD than I was in the past few months. This is valuation, with the fund's discount hitting a level that I feel comfortable buying-in, at almost 4% to NAV:

Source: Nuveen

In fairness, this fund has a history for trading at an even bigger discount but, in this climate, finding relative value is the name of the game. With spreads tight across most of the fixed-income world and equity prices at elevated levels, I see a modest 3-4% discount as a favorably trait.

This is notable because NAD has been trending near its par value, around the 1% discount range, for a while. This is not common for this fund, as it rarely is in premium or par value territory. That is why over the past few months, I have been reluctant to add to my leveraged CEF holdings, as I saw limited value. Now, with prices dropping a bit, I am willing to take on some of the risk the sector is facing because I know I am getting a more reasonable entry point.

So, Why Have Munis Been Dropping?

When valuation is a good metric to consider, we should also think about the reasons why munis have been falling of late. As my readers know, despite being long this sector for a while, I have expressed some caution of late for a number of reasons. Rising valuations was one, but the uncertainty out of DC regarding potential legislative changes is another. To sum up some headwinds the sector is facing, one is the potential for a SALT deduction repeal, which would limit the attractiveness of munis for high-income residents in high tax states. Another is the advance refunding law, which prompted municipalities that wanted to refinance to issue the new bonds in the taxable sector. That caused the taxable sector to grow, and shrunk some of the supply in the tax-exempt, over the past few years. Now, that law is potentially on the chopping block, which could cause more supply in the tax-exempt corner over the next few years.

With respect to supply, aside from the potential legislative changes I mentioned, we are already seeing supply rise in the short-term. While supply has generally been elevated this year, the last few weeks have seen a spike in new issuance, as shown below:

Source: Lord Abbett

As you can see, this helps to explain some of the recent weakness. Rising supply, all other things being equal, is going to pressure underlying values. NAD is a good example. The fund's discount has widened, but its net asset value is still down. It is not simply a matter of market price falling and the NAV staying steady - both have declined.

The point here is that this is not a "sure thing" sector right now, as there are valid reasons for the recent weakness. Yet, munis have been rewarding for me over the longer term, so I continue to view sell-offs like what we are experiencing now as an opportunity to build on buy-and-hold positions.

Inflation Is A Headwind

One additional reason for the recent decline in muni prices that I did not mention about is rising inflation/yields. While interest rates have remained consistent at the Fed, there is growing pressure on the central bank to raise rates, especially in 2022, driven by rising prices across the economy. This is especially relevant to fixed-income, and munis, as these areas have gotten more and more interest rate sensitive as companies and municipalities have taken on more debt for longer time periods. While this has helped shore up balance sheets and improved credit outlooks, it has left investors more exposed to changes in yields and interest rates.

The last month is a good illustration of this. While yields remain at a low level historically, they have absolutely been rising, with the 10-year Treasury moving from the 1.35% level to 1.57% in a relatively short time-frame:

Source: CNBC

So, why does this matter? Well, readers are surely aware that yields move opposite of prices, so rising yields is sending underlying bonds in NAD's portfolio south. Yet, we see that yields are still at pretty low levels, so why is there any real concern here? Shouldn't the fund be able to manage another leg up?

Unfortunately, the problem is that NAD, along with most of the muni CEF market, have seen their duration levels rise. This has left the fund more sensitive to interest rate movements, so the rise in yields is impacting the fund more than it would in a "normal" year. To illustrate, consider that NAD has a duration level above ten years, which means the fund could drop by about 10% if interest rates only move up 1%. That is a lot of risk:

Source: Nuveen

Of course, rates aren't likely to move up 1% anytime soon. Yet, that should still showcase how much risk there is, and how dependent the fund is for rates to remain low. Even a small move higher, like the rise in yields we saw over the past month, can have an outsized impact.

My takeaway here is mainly that investors need to be aware of this and plan ahead accordingly. Have an exit plan ready to reduce exposure if the inflation outlook worsens, as in, gets more aggressive. Investors will not want to have too much interest rate sensitivity in the coming year, if inflation keeps on accelerating. I am not trying to be alarmist here, as I do expect inflation to slow down somewhat, and see rate hikes as 6-9 months away, so having tax-exempt income in the interim continues to make a lot of sense. But I would remain in a comfortable positioning here, not getting too aggressive, and being ready to reduce some exposure if price increases do not settle.

For example, prices continue to rise across the board, driven by higher energy costs especially, as well as supply constraints. This has elevated the costs of moving goods around, with shipping costs in 2021 well above where they were a year ago, as illustrated in the following graphic:

Source: Charles Schwab

The point is that investors need to keep a keen eye on the outlook for inflation, yields, and rates, and remain more nimble in their muni exposure than ever before.

Tax Headlines Remain A Tailwind

I have tried to provide a balanced look at munis, and NAD, so far in this review. But, I did mention at the onset that I am looking to use this sell-off as a buying opportunity, so I must see some bullish attributes out there at the moment. The good news is, I do, especially because of the possibility of tax changes in 2022.

This is a more macro-take on the sector, so it is relevant to NAD, but to the majority of tax-exempt holdings out there. Simply, the Biden administration is making it a priority to push tax reform, and a good chunk of that reform is higher absolute rates for both large-cap corporations and higher-income individuals.

This is important, and should drive muni demand, because these two constituents (corporations and high-income individuals) are the primary buyers of muni bonds are corporations and higher-income individuals. These are two more sophisticated investor classes, and are very proactive when it comes to adjusting their portfolios due to changes in tax rates. At the current moment, there is plenty serious discussion on raising individual rates, with multiple proposals on the table:

Raising Tax Rates Biden administration proposal

Source: Charles Schwab

In addition, the Democratic-majority in the House has proposed also raising the tax rate on corporations, essentially reverting back to pre-2017 levels, as reported recently by Reuters:

Source: Reuters

This should propel more muni demand from companies in sectors that have a lot of cash and need someplace "safe" to put it. This includes banks, insurance companies, and other service firms that need to hold cash in liquid reserves - whether for regulatory or business model reasons. Ultimately, as tax rates increase on corporate America, the thought process is going to be similar to the individual, in the need to shelter generated income from the tax-man.

To be fair, we are already seeing this play out, especially in the banking sector. This makes this thesis very realistic going forward. While new tax rates have not even been passed or gone into effect, banks have begun buying muni bonds again, after selling off some of this exposure post-2017 tax reform:

Bank holdings of muni debt

Source: Yahoo Finance

I take away a couple of things from this graphic. One, the thesis of predicting more corporate muni buying is pretty solid - since it is already happening. However, based on pre-2017 levels, there is plenty of room for more buying on behalf of banks. This reality is probably consistent across other financial services firms. They don't want to go "all-in" yet, before tax hikes actually materialize, so investors can front-run this eventuality by getting in now. The risk, of course, is that tax rates stay constant (or decrease), but given the rhetoric we are seeing out of Congress lately, higher taxes seem the more logical outcome.

Income Metrics Are Solid, Quality Holdings

My final points look at NAD in isolation, and point to a couple reasons why I like this particular one. As an income-oriented product, the distribution income metrics are of critical importance. Fortunately, NAD looks pretty solid at this juncture, which makes me confident the fund will be able to maintain its current level of income. Specifically, the fund has a distribution coverage ratio above 98%, as well as a positive UNII balance to act as a cushion:

Source: Nuveen

This metrics are pretty self-explanatory, so I will suffice to say they are strong enough that I do not have any concerns and I see NAD as a viable income option. In addition, the fund has strong credit quality. The vast majority of the fund's holdings are rated A or better, with only a few junk bonds sprinkled in. There is a sizable weighting that is "not rated", so that is something to keep an eye on, but overall the credit quality is pretty strong:

Source: Nuveen

Again, this gives me confidence on this particular CEF. The fund has a discount to NAV, income metrics that support the current distribution, and quality assets. That spells buying opportunity to me.

Bottom Line

The muni sector will continue to face some ups and downs as legislation makes its way through Congress and investors assess the impact of a myriad of developments. This includes absolute tax rate changes for corporations and individuals, changes to advance refunding requirements, and an elimination of the SALT deduction cap, all items that currently are in debate. Further, inflation remains a headline risk, and given NAD's high duration level, investors do need to monitor this closely. Yet, many positives remain. The fund has seen its discount widen to a more attractive level, and the investment grade assets within the portfolio have very little default risk. With many investors in this space looking for long-term holdings to generate income, buying during times of weakness and uncertainty should help amplify that income and total returns. As a result, I see merit to diving into NAD at current levels, and suggest readers give this fund some consideration at this time.

Please consider the CEF/ETF Income Lab.

This article was written by

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Macro-focused investor, working for a major U.S. bank. I grew up in New York, but escaped to North Carolina. I was a D1 athlete in college (men's tennis) and compete competitively to this day. My Bachelor's and MBA are both in Finance.

I provide reasoned, fact-based analysis of different funds and sectors. I list my portfolio here so readers can gain insight into what I am buying/holding, what I'm not, and how that lines up with the views I present in my articles. 

Broad market: VOO; QQQ; DIA, RSP

Sectors: VPU / BUI; VDE / UCO; KBWB; XRT

Non-US: EWC; EWU; EIRL; EWA

Dividends: DGRO; SDY, SCHD

Municipals/Debt Funds: NEA, BBN, PDO, BGT

Stocks: WMT, JPM, MAA, SWBI, MCD, DG, WM

Cash position: 25%

Disclosure: I/we have a beneficial long position in the shares of NAD, NEA, HYD, BBN, NIQ either through stock ownership, options, or other derivatives. 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.

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