NEA CEF: Looking At The Positives, And A Future Concern (NYSE:NEA)

Main Thesis & Background

The purpose of this article is to evaluate the Nuveen AMT-Free Quality Municipal Income Fund (NYSE:NEA) 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 the alternative minimum tax applicable to individuals by investing in an actively managed portfolio of tax-exempt municipal securities”.

When I covered NEA around this time last year, I was bullish on the fund. I had under-estimated how long the yield curve was going to be inverted (pressuring leveraged CEFs) and how aggressively the Fed was going to hike rates. The net result was a relatively weak showing by NEA since that review:

With this in mind, I wanted to approach NEA with a critical lens in 2024 so I don’t get it “wrong” again. Fortunately, the horizon has cleared a bit for fixed-income in general, and that is a positive for this fund along with the broader muni sector. There are also a couple micro-developments for NEA specifically that suggest this is still a reasonable buy here even after the Q4 surge. However, there are some headwinds to be aware of, so I will use this article to discuss both the risks and the potential going forward.

What’s The Good News? Income Boost, Q4 Rally

To begin, let us look at what has been working for NEA of late. As readers are surely aware, the bond market in the US held a fairly strong rally to end last year on the news the Fed was pausing rate hikes and may even begin to cut rates this calendar year. NEA got caught up in the wave of buying as both retail and institutional buyers returned to this sector after fleeing it in droves over the past 12-18 months. The net result is a gain for NEA of near 20% off its lows, once distributions are accounted for:

This is part of why we need to look forward with a bit of a discerning eye. The fact is that NEA has already had a big surge, so planning on another double-digit pop in the near term is likely to disappoint. This momentum is a sign of confidence, and that is overall a very good thing, but it can limit the opportunity ahead. My followers know I am not an endless pumper of stocks or funds, even the ones I own, so when I see gains of this nature I have to suggest some level of caution – even when there are other positive attributes that can continue to push the fund higher (which there are in this case). So keep an open mind and resist the urge to get too aggressive at these levels.

Another positive that will help forward returns is the fund’s recent income boost. This was a large, 21% bump that has corrected some of the cuts we saw in the fund’s trading history:

This has sent the current yield above the 4.5% level, which puts it on par with many other fixed-income assets like savings/CD accounts, treasuries, and corporate bonds. We have to remember that on a tax-adjusted basis, NEA’s yield is probably more attractive than most of those alternatives if someone is in a higher income tax bracket. This is purely dependent on each individual’s unique situation and should be weighed carefully. But a higher income stream, with tax benefits, is clearly a catalyst to why NEA’s fortunes have improved since Q4 and are likely to support more gains in Q1 as well.

Income Boost Needs To Be Understood

While the prior paragraph was a bit of a cheer-leading section, I will reiterate there is no such thing as a “sure thing” in investing. Even for funds like NEA that I have favored for a long time, I resist the urge to blast out silly headlines like “buy hand over first”, it is “set to soar”, or “the more it drops, the more I buy”. I find that type of speculation to be a disservice to serious investors, because a clear understanding (and analysis) of risks – which are always present is needed to make a risk-based decision on any investment before allocating your hard earned cash to it.

Why do I bring this up now? Because NEA is not immune to criticism even if I am going to place a “buy” rating on it. The fund’s income story is one that requires a deep dive, even though I just suggested the hike to the distribution was a catalyst for gains and potentially for more to come.

That begs the question – why? The reason is that Nuveen did not boost this distribution because the tide had fully turned in terms of NEA’s declining income story. NEA had been struggling for a long time with an inverted yield curve and limited opportunities at the longer end of the muni curve. Fees and borrowing costs cut in to NEA’s income-earning ability, and the two cuts in the prior 18 months speak to that.

But fast forward to the present, and the distribution was just raised. So, what changed? The reality is Nuveen raised this in an effort to draw in investor interest. I am not saying there is anything wrong with doing that. Quite the contrary. If a fund is trading at under-valued levels and/or can support a higher payout in the short-term, as a “dividend seeker” I’m all for some return of capital to my account in some instances. But I am emphasizing this so readers understand that NEA didn’t boost its distribution because the underlying assets are suddenly earning a higher yield. That is not the case.

For further support, consider the press release from Nuveen when it announced NEA’s income boost (along with a handful of other municipal bond CEFs it manages). That release specifically says this was an effort to support trading (i.e. help push the price higher) and that “return of capital” will be utilized as a source to maintain this payout:

The significance here is that NEA’s income challenges have not gone away just because the distribution was raised. In normal times this type of statement may sound counter-intuitive, but in this case it is a fact. Nuveen is hoping that a higher yield will help to correct the persistent double-digit discount and reward current holders through a temporary income boost and then (hopefully) share price appreciation as investors rotate in to the fund.

The challenge with this approach is that there is no guarantee investors will continue to pile into a higher income stream if the stream is not sustainable. While I do not believe Nuveen is going to reset the level lower any time soon, that adjustment is going to have to happen eventually unless the macro-environment changes. This clouds the income story, changing what could have been a clear tailwind into a backdrop that needs to be carefully evaluated.

What should be understood by now is that NEA is an expensive fund to run and own. Management expenses add up, and borrowing costs have surged during the Fed’s rate-hiking path. While the latter’s impact is starting to be mitigated, readers need to realize the yield curve is still inverted and the Fed has not begun to cut rates yet. This means extensive borrowing costs will continue to eat away at NEA’s potential returns to shareholders:

The positive takeaway is the inversion has started to “un-invert” despite remaining inverted. This means the gap between what short-term debt is offering compared to long-term debt has been narrowing – quite dramatically in the last couple of months. That removes some of the challenge for leveraged CEFs as we begin a fresh calendar year, but we are not out-of-the-woods yet. So keep an eye on any development and recognize that if this trend does not continue in the right direction in Q1, NEA will suffer.

Discount To NAV Persists

Another factor to keep in mind is that even with NEA’s recent push higher, the inherent value is still represented in the market price. At the time of my review last year, NEA had a double-digit discount to NAV at around 11%. Today, that story is even more attractive for value-oriented investors as it has risen in excess of 14%:

I view this positively because it should help limit downside in the share price in the immediate term. NEA is clearly in value territory, but investors in the fund now that a double-digit discount is the norm for NEA, not the exception. So I would not make the case that NEA is going to see a sharp rally on the backdrop of consistent discount narrowing. Could the discount narrow? Yes, it could, and I believe it will to a degree. But I wouldn’t expect more than a 2-4% pop from this attribute, because trading at par is not my expectation for NEA in 2024. So keep that in mind when evaluating potential forward returns.

Health Care Assets Have Some Support

Digging in to NEA on an individual level, part of the reason for this fund’s poor performance is its heavy allocation to health care. This can be in reference to REITs, hospitals, doctor’s office parks, and assisted living facilities, among others. Certainly since the pandemic began, this is a sector that has faced many challenges and has been a bit of a thorn in the side of NEA and other muni funds that hold this type of debt:

The good news is that the future is not the past. This sector is one that actually benefited from a large amount of federal support and held off on borrowing last year when borrowing costs surged. To start 2024, it is cheaper to issue in the muni market, and hospitals appear to be well aware of this fact. They are taking advantage of new issues in a big way so far this January:

At the same time, other pressures on hospitals, such as labor costs, have stopped accelerating at such a rapid pace as the labor market has begun to normalize. As patient demand for elective surgeries has also returned (after seeing people delay treatment during the worst of the pandemic), many hospitals are finding they have enough “cash on hand” to not set-off major alarm bells. While plenty of hospital systems are in need of support, they are a small number in proportion to the whole system. This makes it important for fund managers to be discerning, but recent data from the Kaiser Family Foundation shows that the sector as a whole is not at-risk:

What I conclude from this is that we shouldn’t be in “panic mode” with respect to this sector. I trust that Nuveen’s management will steer NEA away from the more at-risk hospital and health care systems and, given those issues represent a manageable percentage of the broader sector, I am comfortable with this exposure. The US health care system certainly has plenty of flaws, but the hospital sector is starting 2024 off with a reasonable cash position, has taken advantage of declining borrowing costs, and has seen some labor concerns start to ease. All of this is assuring for NEA holders.

Bottom-line

Fixed-income saw a bump to wrap up 2023 and there are signs more gains could be on the way. This extends to the municipal bond sector and the CEFs that own those bonds – such as NEA. Major macro-catalysts include declining inflation, which has allowed the Fed to pump the brakes, supporting a rotation back in to bonds:

Simultaneously, US equities are looking richly priced relative to both their own trading history and the rest of the world. The implication here is that investors may be looking for US equity “hedges”. This can mean a lot of things – such as non-US equities. But it could also mean safer assets that are closer to home, such as muni bonds:

All of this adds up to an environment that is supportive of muni debt in my view. After a rock-star year for equities in 2023, they begin 2024 richly priced in the US. Further, inflation has come down, giving the Fed a more dovish slant, which is supportive of fixed-income. Finally, NEA has seen an increase to its distribution, trades at a large discount to NAV, and holds debt in a sector (health care) that has improving fundamentals. The net result is I am willing to slap a “buy” rating on this fund as we dive deeper in to January.