NMZ: The Muni Market Is Changing, Pressuring Future Yields – Nuveen Municipal High Income Opportunity Fund (NYSE:NMZ)

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Main Thesis

The purpose of this article is to evaluate the Nuveen Municipal High Income Opportunity Fund (NMZ) as an investment option at its current market price. NMZ is a CEF that invests in municipal ((muni)) debt on a national scale, which has been a sector I have been bullish on for most of 2019. However, I have recently turned more cautious on the sector. While I still believe in the underlying objective, delivering a tax-free income stream, there are other developments that suggest a more neutral stance is appropriate going in to 2020. One, the sector has had a great year, and I feel the SALT deduction story is well known at this point. While investors in high-tax states will continue to see the value in muni debt, major moves have likely already been made at this point, so I would anticipate more reasonable returns. Two, local governments are beginning to refinance muni debt, on the taxable side. While tax-free debt issues are restricted from doing the same, governments have been working around this law and offering “delayed” bonds, which offer settlement in the future. This has allowed municipalities to take advantage of lower yields without risking the tax-free status and, if this trend continues, will likely drive yields down across the sector in the future.

While this outlook presents a less bullish stance than I previously had, I still see value in funds like NMZ. As mentioned, tax-free income streams should remain in demand, and this fund trades at a reasonable valuation, which sets it apart from many of the PIMCO muni CEFs I follow. Further, as volatility has reemerged in the market, investors may be looking for an equity hedge. Muni debt offers investors a low correlation to the major indices.

Background

First, a little about NMZ. It is a closed-end fund with an objective “to provide high current income exempt from regular federal income tax. Its secondary investment objective is to seek attractive total return consistent with its primary objective.” Currently, the fund trades at $14.19/share and pays a monthly distribution of $.0595/share, which translates to an annual yield of 5.03%. I covered NMZ for the first time in August, and slapped a “neutral” rating on the fund. In hindsight, this call appears appropriate, as the fund has barely moved since that time, while the equity market has performed well:

Source: Seeking Alpha

Considering how the market has been trading in the short-term, I wanted to do an updated review to offer my outlook for muni debt as a whole, and specifically NMZ as a way to play invest in the sector. After careful review, I believe maintaining a “neutral” rating on the fund is appropriate, and I will explain why in detail below.

Taxable Muni Market Could Be A Sign Of What’s To Come

To begin, I want to first discuss a recent trend in the taxable muni market, and how this may be relevant to funds like NMZ in the near future. Of course, NMZ’s strategy is to own tax-free muni bonds, so investors may be wondering why the taxable sector is relevant here. The reason is that there has been a development going on within that sector which I believe may spill over to the tax-free muni bond sector, and may impact future distributions.

The point I am referring to is the recent refunding of taxable bonds. As interest rates have declined, this has pressured yields across the fixed-income world, but muni bonds had been largely unaffected until recently. As investors are likely aware, the Federal Reserve cut interest rates for the third time this year in their October meeting. As rates continued to move lower, municipalities have decided to take advantage of this trend and refinance existing taxable bonds to lower their interest expense. And the activity has been robust, with taxable muni bond refinancing jumping after the July interest rate cut from the Federal Reserve, and seeing a similar increase in November following the October cut, as shown below:

https://static.seekingalpha.com/uploads/2019/11/20/10779721-1574284290096459.png

Source: Bloomberg

While taxable munis obviously do not have the same tax advantages as their tax-free counterparts, the sector is clearly seeing quite a bit of activity, and investors are buying. A couple reasons for this is that the income, while taxable, is still attractive, considering the decline in treasury yields. A second reason is that many foreign buyers are opting to purchase these bonds, primarily because they are not as concerned about U.S. tax savings and yields in their own countries may be lower, or even negative.

So why is this relevant for NMZ? The reason is the muni market appears to be finally taking advantage of lower rates, and aggressively refinancing old debt. This is going to lower forward yields for the sector, and is already starting to impact current income streams. For example, consider BlackRock’s (BLK) Taxable Municipal Bond Trust (BBN). This fund predominately holds taxable muni debt, and its distribution recently saw a decline of 6%, as some of the holdings were impacted by the lower rates.

While funds like NMZ, which hold tax-free bonds, have not yet faced similar distribution cuts, I believe this illustrates a cautionary tale that investors need to consider going forward. What is happening in the taxable sector could spill over in to the tax-free sector. While a significant part of the 2017 tax reform prevents municipalities from refinancing tax-free bonds with similar tax-free offerings, there have been attempts by local governments to circumvent this rule, which tells me yields are likely to see similar declines. I will discuss this point further in the following paragraph.

Delayed Delivery Bonds Will Pressure Returns

After digesting my prior paragraph, investors may be thinking “the law states tax-free bonds cannot advance refund, so the risk for NMZ is moot”. While that line of thinking has been accurate up until now, there has been a growing trend in the tax-free muni market that is circumventing that rule and has the ability to impact future yields. Specifically, this is the issuance of “delayed delivery” bonds. These are bonds which do not settle immediately, but rather months, or even years, in the future. This has been the latest tactic to take advantage of lower yields within the tax-free muni market, without actually refinancing existing bonds. Therefore, while current yields may not be pressured immediately, they will once the newly issued, lower yielding bonds eventually settle.

And this is not a minor occurrence. With interest rates declining markedly this year, local governments are eager to issue these delayed bonds. While this has been going on throughout 2019, it has accelerated in recently. To illustrate, consider the chart below, which shows there has been almost $10 billion of delayed delivery muni bonds sold this year, more than double what we saw in 2017 or 2018:

Source: Bloomberg

Clearly, this is a growing trend. In fact, according to the data compiled by Bloomberg, over $1.4 billion of these bonds were issued in October alone.

My point here is if this trend continues, we will likely see income cuts across the tax-free muni space, similar to what is playing out right now within the taxable muni sector. In fairness, NMZ has a very positive income story so far in 2019, with the fund increasing its distribution back in April, as shown below:

Source: Nuveen

Further, NMZ has actually since its income safety net improve since my last review. The distribution coverage ratio remains above 105%, and the UNII balance has grown by about $.01/share. To illustrate, consider the UNII report utilized during my August review, compared against the most recent report from Nuveen, respectively:

Source: Nuveen

My overall takeaway here is that NMZ seems to be in good shape, and its distribution appears safe, for now. I don’t see any major red flags to suggest an immediate distribution cut. However, given the trends in the muni market right now, I find it unlikely NMZ will be able to maintain this yield for the longer term, and would caution investors to expect lower yields in the future.

NMZ’s Valuation Still Reasonable

I now want to shift to some reasons why I believe NMZ could hold up well going forward. While my article thus far has been advocating caution, I am by no means “bearish”, and expect positive, but mild, returns going forward. A key reason for this, specifically for NMZ, is the fund’s valuation. While I cover multiple muni debt CEFs, many are from PIMCO and sport aggressive premiums. This makes me cautious, especially when the market gets volatile, as it has lately. Therefore, in times like this, I look for suitable alternatives that have more reasonable valuations, and NMZ fits this bill.

Specifically, NMZ’s valuation is little changed since my last review, which makes sense since its return was essentially flat. With a premium just over 1%, the fund does not appear expensive. While it is certainly cheaper than the PIMCO alternatives, I do want to emphasize that is it not “cheap”, especially considering its own trading history. While a 1% premium is not unreasonable, this is a fund that has a habit of trading at a discount to NAV, as the chart below illustrates:

Current Premium 1.2%
Average 1-Year Premium (based on month-end valuation) (1.60%)
1-Year High 3.5%
1-Year Low (12.3%)

Source: Nuveen

As you can see, NMZ’s current premium is closer to its annual high than its annual low, so this would suggest limited upside from here. However, I do not see significant downside risk either, since I expect muni debt to remain attractive in the new year.

A second point on why this premium has not gotten even higher this year has a very positive slant. Due to the strong demand in muni debt nationwide, the underlying value of NMZ has increased markedly since the end of last year, as the chart below illustrates:

NAV 12/31/18 NAV 8/23/19 NAV 12/2/19 YTD Gain Gain Since Aug Review
$12.98 $13.97 $14.02 8.0% Flat

Clearly, NMZ has seen its value rise in 2019. However, it is clear that recent gains have been limited, as we can see the NAV return since late August has been flat. As we see an uptick in muni issuance to capture lower yields, I would expect limited gains to the NAV heading in to 2020, which is a key point behind my “neutral” outlook.

Munis Still Make Sense As An Equity Hedge

My final point on NMZ is that while my outlook on muni debt is no longer as bullish as it once was, I see plenty of merit to owning this sector, especially if investors are expecting further equity volatility. While the market has been very complacent in Q4, the start of December has changed all this. As I write this (on 12/3), the Dow Jones Index (DJI) has lost 500 points this week, as trade concerns dominate headlines once again. While the market still sits within a few percentage points of its all-time high, investors are likely getting nervous, and may be looking for ways to limit downside risk going in to 2020.

On this point, I believe fixed-income in general, and funds like NMZ, could offer some peace of mind. Even if the equity market continues to pull back, there is plenty of downside left. This is because forward multiples are quite rich, with the forward P/E for the S&P 500 resting above historical norms. The current level of 17.7 is well above the longer term median, as shown below:

Source: Charles Schwab

My takeaway is to reiterate that I am continuing to see less value in the broader equity markets, and remain focused on limiting downside risk going forward. Muni funds like NMZ offer a reasonable way to profit off further market volatility, and remain a safe place to park cash while waiting for better entry points to the major indices.

Bottom Line

NMZ has been treading water since my last review, and I am reiterating my “neutral” rating. The fund will likely see pressure to its income stream in the future, due to lower interest rates and the willingness of municipalities to get creative in capturing lower yields. However, I see positives as well. NMZ has seen its NAV grow in 2019, and its valuation remains very reasonable. Further, the sector offers investors an equity hedge, which may see renewed interest given the market movement so far this week. Therefore, I would recommend investors consider NMZ as an investment option if they are looking for relative safety and a tax-free income stream, but to also be realistic about total return expectations going forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

2019-12-04 16:17:00

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