NAD: Barely A Dip Reflects Underlying Strength

Bonds are dropping on “higher for longer” rate expectations, and I view the dip as a buying opportunity. I am particularly attracted to longer-term bond funds, and the Nuveen Quality Muni Income Fund (NYSE:NAD) caught my eye, not because it has dipped to an attractive buy point; quite the contrary, it has dipped very little, but this relative strength often reflects good fundamentals and could mean it is insulated from external shocks.

A Sector With Attractive Relative Strength

NAD has a portfolio of municipal securities with an average maturity of 18.77 years. As such, it has similar interest rate sensitivity to the iShares 20+ Year Treasury Bond ETF (TLT) and tends to correlate closely.

However, there has been a clear outperformance in NAD over the last three years and the divergence is widening. Importantly, NAD has held up much better during the recent downturn and is outperforming by a significant 6.61% over the last six months.

This relative strength is desirable. Not only should NAD be insulated against macro downturns, it could also outperform during rallies. Moreover, the fund has an attractive -14.90% discount to NAV. This time last year, the discount was -12.5%. Another draw comes from its 5.66% dividend, which was raised in March.

All that said, compared to other Munis in its peer group, NAD is underperforming over the last six months.

Longer term, over the last five years, NAD does slightly better, although it is notable the entire sector has performed poorly due to the huge drawdown in 2022-2023.

I do think this poor performance is in the rear mirror; bonds (and Munis) should have bottomed, and any dip is a buying opportunity. The Fed is done hiking and will almost certainly cut this year, even if inflation nudges up and delays the cuts until September.

A Closer Look at NAD

Distributions and Expenses

NAD is a leveraged CEF, which, according to the Fund Page, “invests in municipal securities that are exempt from federal income taxes.” It provides holders with a monthly tax-free distribution which currently yields 5.66% based on the last pay-out.

After declining distributions in 2022 and early 2023, the distributions are rising again, and increased in March.

While this is attractive, the increase in distributions is funded by return of capital (ROC) and the distribution coverage ratio has dropped to just 74%.

This may be off-putting, and the high expense ratios are also a red flag.

Every percent is important when buying a fund for yield. That said, the expenses are complicated by leverage and other factors which may add to the expenses but boost the overall performance. I therefore refer back to the total returns, which still compare favorably to many bond ETFs, but lags its peers in the Muni space.

Performance Matters

The increased distribution clearly hasn’t boosted NAD’s relative performance over the last six months. Neither has the use of leverage, which is mostly in preferred shares, but also in tender option bonds. The fund has a high effective leverage of 40% which may be expensive in a high rate environment like we are in now.

The maturities of its 1183 holdings provide some flexibility and since the average maturity is lower than, for example, TLT, the recent rise in rates has hurt it less.

NAD does have an attractive discount to NAV of -14.9%. This was pulled lower as NAD’s price collapsed from 2022 to October 2023 when the discount hit an extreme -17.6%. 2008 was the only time it has traded at a deeper discount.

Fund Holdings

NAD’s holdings are well diversified, and no single holding is more than 1% of the fund.

Furthermore, the diversification extends to sectors.

And States.

My only small gripe is the declaration of “quality” in the fund’s name. Yes, the vast majority are investment grade of BBB or above, and this is an overall safe portfolio, but with 4.7% of the fund in BB and even C rated investments, the quality could be better.

Other Considerations

NAD has $3.02B AUM. It is actively managed by Stephen J. Candido, CFA and Michael S. Hamilton, who employ a bottom-up stock picking approach to find underrated or undervalued investments.

The average daily volume in shares is an ample 1,045,485.

Conclusion

NAD is an attractive closed end fund with a healthy 5.66% dividend and tax free monthly distributions. The use of leverage, maturity breakdown, diversification and discount to NAV are all positives and have led to outperformance versus traditional bond ETFs such as TLT. Compared to other Munis, however, its performance is less impressive and there may be better opportunities in this sector.