How Nuveen's High Yield Fund Beats the Market

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The Nuveen High Yield Municipal Bond Fund has outperformed its benchmark by 10% over the last five years by keeping duration a bit longer and adding value through security and sector selection, according to portfolio manager John Miller.

The longer duration adds more yield compared with the Standard & Poor's Municipal High Yield Index benchmark that the fund aims to replicate, helping to maintain the fund's position among top performing high yield municipal funds over the one, three, and five years, Miller told The Bond Buyer.

"The yield-curve positioning, which is generally a touch longer than the benchmark, is value added," said Miller, co-head of fixed income at Nuveen Asset Management.

Its effective duration is a little over 10 years. The $12.5 billion fund invests primarily in non-investment-grade and unrated municipal bonds that under normal market conditions will maintain a weighted average maturity in excess of 10 years as it seeks to provide high current income exempt from regular federal income taxes, according to a description on the nuveen.com website.

The fund's Class A shares, ticker NHMAX, has average annualized total returns of 6.17%, 6.24%, and 10.92% over one, three, and five years, respectively, according to data on Nuveen.com. That compares with the S&P Municipal High Yield Index, which returned 5.02%, 4.34%, and 8.31% over the same periods, respectively.

It also has a 5.40% average annualized total return since its 1999 inception. Miller said the fund's performance is steady despite the ripe conditions for a yield curve flattening.

"The pre-conditions are getting closer and closer to a possible moderate rate increase, but probably not more than one," either next month or later in the year, Miller predicted.

With strong global demand for U.S. securities, he said municipals have remained less volatile than Treasuries given the moderate supply conditions and robust demand – and that has helped his strategy and his fund.

High-yield muni funds reported inflows of $372.212 million in the week ending May 18, after inflows of $309.525 million the previous week.

Nuveen's High Yield Muni Fund has over 2,000 positions with exposure throughout the yield curve, but its average maturity and heaviest weighting is in 20 years, the managing director said.

"Generally speaking, longer bonds – given the steepness of the yield curve – are likely to outperform than shorter bonds," he said. "High-yield has been outperfoming and can continue to outperform" in the absence of broad spread widening, Miller said.

Generally, the fund operates with a big picture view of identifying maximum opportunities for yield and stable security features, however, bonds are considered on a case by case basis, he said.

At the same time, nonrated bonds consist of 39.8% of the fund's exposure, followed by single B and double A bonds at 13.8% each.

Other distinctive characteristics of the fund's performance includes its ownership of real estate and collective property tax securities, which finance infrastructure in community development, metropolitan, and tax increment financing districts, as well as redevelopment agencies. The securities the fund owns include, for instance, Mello Roos bonds in California and Liberty bonds in New York. One of its largest holdings is New York Liberty 3 World Trade Center bonds, which have outperformed since first being issued at the end of 2014, Miller said. The fund owns Liberty bonds with a 5% coupon and 3.85% yield, as well as the 7 1/4% coupon bonds with 3.99% yield.

"When you combine them together, it's our most important exposure," he said of the combined real estate and collective tax sectors, which he said represents 24.5% of the fund and has four of Nuveen's 23 credit analysts dedicated to monitor it. Security selection has led the fund to become actively engaged in Chicago area land credits as volatility due to underfunded pensions and political gridlock in the fiscally-troubled city and state has cheapened its bonds compared to many individual project type bonds, Miller said.

"There are some overlooked strengths that get buried behind all the politics and we think those strengths will enable the city to recover," he said.

A new plan to fix the city's underfunded pension funds is awaiting approval by state lawmakers and the governor, though progress on the pension front also could be overshadowed by the state's ongoing budget impasse and the Chicago Public Schools' funding crisis.

"I think the city has the wherewithal to address the main problems," Miller said. "We have yet to see a case of just pension underfunding alone taking an entire city down and I don't think Chicago will be that city."

Two other sectors that share a prominent presence – and where excess yield and security selection contribute to the fund's performance – are health care at 13.5%, and charter schools at 8%, according to Miller.

The excess yield in these sectors help offset the incremental spread narrowing that has surfaced in the last few years, even though they haven't been nearly as volatile as in the Puerto Rico or tobacco sectors, he said.

"When you add the yield we get out of those sectors that has been a positive to the fund's stability of [net asset value] and price of the bonds," Miller explained.

The fund enhances performance by adding some credits, and by avoiding others. Miller said the fund reaps benefits from limiting its ownership of the two "most volatile" sectors in the municipal market. He said it remains underweight in tobacco bonds relative to its peers, and maintains zero exposure to Puerto Rico paper as it has done for the last few years.

The combination has been largely rewarding, given that the commonwealth has recently been an underperformer, and tobacco has been an outperformer, according to Miller.

"We benefit from zero exposure to P.R., but run the risk of being held back a little by not having as much tobacco as our peers," he said.

The fund will continue to avoid Puerto Rico for the foreseeable future as the restructuring plans are uncertain, the Congressional intervention is pending, and its economic decline and outmigration continue to threaten its already ailing fiscal health, Miller said.

"That just adds to the numerous points of uncertainty and unpredictability, and with that kind of unpredictability, we are better off looking at it post-restructuring," Miller said.

"Zero P.R. paper has been extremely helpful, and having some tobacco exposure, we have had to make up relative performance in other ways," such as its reliance on over weighted exposure to the real estate, health care, and charter school sectors, he added.

Another risk prevention strategy the fund maintains is keeping its exposure to continuing care retirement communities to approximately 5%, Miller said.

"The sector as a whole has a few more problems in it than the community development district sector and we prefer a direct lien on collecting property taxes," to having a mortgage on one nursing home or senior living center, he said.

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