Fitch Takes Various Rating Actions on Nuveen Muni CEF Preferred Shares on Reorganization
OREANDA-NEWS. Fitch Ratings has affirmed and assigned the following ratings to the preferred shares issued by two municipal closed-end funds (CEFs) managed by Nuveen Fund Advisors, LLC (NFA) and subadvised by Nuveen Asset Management, LLC (NAM):
Nuveen Enhanced Municipal Credit Opportunities Fund (NZF)
--$268,800,000 of VRDP Shares, Series 1, final mandatory redemption on March 1, 2040, rated 'AAA/F1+'. The liquidity provider is JPMorgan Chase Bank, N.A. ('AA-/F1+');
--$262,200,000 of Variable Rate Demand Preferred Shares (VRDP Shares), Series 2, final mandatory redemption on March 1, 2040, rated 'AAA/F1+'. The liquidity provider is JPMorgan Chase Bank, N.A. ('AA-/F1+');
--$196,000,000 of VRDP Shares, Series 3, final mandatory redemption on June 1, 2040, rated 'AAA/F1+'. The liquidity provider is the Toronto-Dominion Bank (TD Bank, 'AA-/F1+');
--$150,000,000 of Institutional MuniFund Term Preferred Shares (iMTP Shares), Series 2017, term redemption on Oct. 1, 2017, affirmed at 'AAA';
--$81,000,000 of Variable Rate MuniFund Term Preferred Shares (VMTP Shares), Series 2017, term redemption on April 1, 2017, affirmed at 'AAA'.
Nuveen Enhanced AMT-Free Municipal Credit Opportunities Fund (NVG)
--$179,000,000 of VRDP Shares, Series 1, final mandatory redemption on Dec. 1, 2043, affirmed at 'AAA'.
--$385,400,000 of VRDP Shares, Series 2, final mandatory redemption on Dec. 1, 2040, rated 'AAA/F1+'. The liquidity provider is JPMorgan Chase Bank, N.A. ('AA-/F1+');
--$667,200,000 of VRDP Shares, Series 3, final mandatory redemption on Dec. 1, 2040, rated 'AAA/F1'. The liquidity provider is Citibank, N.A. ('A+/F1');
--$240,400,000 of VMTP Shares, Series 2018, term redemption on Dec. 1, 2018, rated 'AAA';
The rating actions are taken in connection with the fund reorganization described below.
KEY RATING DRIVERS
The short-term ratings of the VRDP Shares of NZF and NVG primarily reflect:
--The credit strength of the VRDP Shares' liquidity providers noted above;
--The terms and conditions of the VRDP Shares purchase agreements.
The 'AAA' long-term ratings of the VRDP, VMTP and iMTP Shares primarily reflect:
--Sufficient asset coverage provided to the preferred shares as calculated per each fund's over-collateralization (OC) tests;
--The structural protections afforded by mandatory de-leveraging provisions in the event of asset coverage declines;
--The legal and regulatory parameters that govern each fund's operations;
--Both the short- and long-term ratings also reflect the capabilities of NFA as investment advisor and NAM as subadvisor.
Nuveen Investments, Inc. (Nuveen) announced the closing of a fund reorganization on April 11, 2016 whereby target funds Nuveen Premium Income Municipal Fund 4, Inc. (NPT), Nuveen Dividend Advantage Municipal Fund 2 (NXZ) and Nuveen Municipal Advantage Fund, Inc. (NMA) were each reorganized into acquiring fund NZF. NZF was named Nuveen Dividend Advantage Municipal Fund 3 prior to the merger.
Also on April 11, 2016, Nuveen announced the closing of a fund reorganization whereby target funds Nuveen Municipal Opportunity Fund, Inc. (NIO), Nuveen Quality Municipal Fund, Inc. (NQI), and Nuveen Quality Income Municipal Fund, Inc. (NQU) were each reorganized into acquiring fund NVG. NVG was named Nuveen Dividend Advantage Municipal Income Fund prior to the merger.
As a result of the reorganizations, substantially all the assets and liabilities of the listed target funds have become assets and liabilities of the applicable acquiring fund. The reorganizations have been approved, as applicable, by the common and preferred shareholders of the acquiring and target funds.
Upon the closing of the reorganizations, holders of the preferred shares of the target funds received, for each preferred share held immediately prior to the reorganization, one preferred share of the same type having substantially the same terms in the case of VMTP Shares and substantially similar terms in the case of VRDP Shares. Fitch now marks the preferred shares the target funds as Paid in Full.
The acquiring funds are closed-end management investment companies regulated by the Investment Company Act of 1940 (the Act). Prior to the reorganization, the target and acquiring funds invested in municipal securities that are exempt from regular federal tax, and were permitted to invest up to 20% of assets in below investment grade and / or unrated securities.
Subsequent to the reorganization, NZF and NVG will continue to invest primarily in municipal securities that are exempt from regular federal tax, and NVG will invest in securities free from alternative minimum tax (AMT) as well as regular federal tax. However, after the reorganization, NZF and NVG will have expanded investment mandates that will permit them to invest up to 55% of assets in municipal securities rated 'BBB' or below, including below investment grade securities or unrated securities of comparable quality. Fitch expects the repositioning of the funds' portfolios to take place over time.
FUND LEVERAGE AND ASSET COVERAGE
As of March 31, 2016, total assets, including the impact of the reorganizations on a pro forma consolidated basis, was about $3.5 billion for NZF and $5.2 billion for NVG. Total leverage on a pro forma consolidated basis consisted of approximately $958 million of preferred shares and $232 million of tender option bond obligations (TOBs) for NZF and $1.47 billion of preferred shares and $382 million of TOBs.
As of March 31, 2016, asset coverage for the total outstanding preferred shares of NZF and NVG on a post-reorganization pro forma consolidated basis, as calculated in accordance with the Act, was in excess of the Minimum Asset Coverage of 225% required by the governing documents for the applicable preferred shares.
As of March 31, 2016, the effective leverage ratio on a post-reorganization pro forma consolidated basis was 34% for NZF and 36% for NVG%. These effective leverage ratios are below the 45% Maximum Effective Leverage Ratio allowed by the applicable governing documents for the iMTP Shares and VMTP Shares, and governing documents and agreements with liquidity providers for the VRDP Shares.
In the event of asset coverage declines, the funds' governing documents require the funds to reduce leverage in order to restore compliance with the applicable asset coverage test.
Minimum Asset Coverage compliance is tested daily for the iMTP Shares, and VMTP Shares and monthly for the VRDP Shares. Compliance with the Effective Leverage Ratio is tested daily for iMTP Shares, VMTP Shares and VRDP Shares.
For iMTP Shares, VMTP Shares and VRDP Shares, failure to cure a breach of the Minimum Asset Coverage requirement by the allotted cure date results in mandatory redemption of sufficient preferred shares to restore compliance. To facilitate redemption, the applicable fund will deposit sufficient proceeds with a third-party tender and paying agent. The time allowed for the applicable fund to restore compliance is consistent with Fitch's 60-business-day criteria guideline.
For iMTP and VMTP Shares, a breach of the Effective Leverage Ratio threshold requires the fund to redeem a sufficient number of preferred shares, and / or reduce the amount of TOBs the fund has outstanding in order to restore compliance. The time allowed for the funds to restore compliance is consistent with Fitch's 60-business-day criteria guideline.
For VRDP Shares of each series, a breach of the Effective Leverage Ratio is a breach of the fee agreement with the applicable liquidity provider and, at the option of the applicable liquidity provider, may result in mandatory tender of VRDP Shares of the applicable series for remarketing (see the VRDP Purchase Obligation section below for additional details). However, in the event of a breach Fitch expects the fund to redeem a sufficient number of preferred shares or reduce the amount of TOBs outstanding in order to restore compliance. The allotted time to restore compliance to the Effective Leverage Ratio test is consistent with Fitch's 60-business-day criteria guideline.
VRDP PURCHASE OBLIGATION
The short-term ratings assigned to the VRDP Shares of each series are directly linked to the short-term creditworthiness of the associated liquidity provider. The VRDP Shares are supported by a purchase agreement to ensure full and timely repayment of all tendered VRDP Shares of the applicable series plus any accumulated and unpaid dividends. The purchase agreement is unconditional and irrevocable.
The VRDP purchase agreement requires the liquidity provider to purchase all VRDP Shares of the applicable series tendered for sale that were not successfully remarketed. The liquidity provider must also purchase all outstanding VRDP Shares of the applicable series if the fund has not obtained an alternate purchase agreement prior to the termination of the purchase agreement then in effect if not extended at the scheduled termination date or following the downgrade of the liquidity provider's rating below 'F2' (or equivalent).
The liquidity provider's role under the fee agreement relating to the purchase obligation for each applicable series has a scheduled termination date. Prior to the scheduled termination date, the fee agreement can be extended to a new scheduled termination date, or a new liquidity provider may be selected. Any future changes to the terms of the fee agreement that weaken the structural protections discussed above may have negative rating implications.
Fitch performed various stress tests on NZF and NVG to assess the strength of the structural protections available to the preferred shares compared to the rating stresses outlined in Fitch's closed-end fund rating criteria. These tests included determining various 'worst case' scenarios where the funds' leverage and portfolio composition migrated to the outer limits of the funds' post-reorganization operating and investment guidelines.
Asset coverage available to the preferred shares fell below the 'AAA' threshold, and instead passed at the 'AA' rating level only under remote circumstances, such as increasing the fund's leverage to 45% as well as increasing issuer concentration while simultaneously migrating the portfolio to a level of 55% high yield bonds, the highest allowable under the fund's post-reorganization expanded investment mandate.
Given the highly unlikely nature of the stress scenarios, and the minimal rating impact at the target leverage level, Fitch views the permitted investments, municipal issuer diversification framework, and mandatory deleveraging mechanisms of NZF and NVG as consistent with the 'AAA' ratings assigned to the preferred shares.
The investment advisor for NZF and NVG is NFA, a subsidiary of Nuveen Investments. NFA is responsible for the fund's overall investment strategies and their implementation. The sub-advisor, NAM, is a subsidiary of NFA that oversees the day-to-day operations of the fund. Nuveen Investments and its affiliates had approximately $225 billion of assets under management as of Dec. 31, 2015.
The ratings assigned to the preferred shares may be sensitive to material changes in the leverage composition, portfolio credit quality or market risk of NZF or NVG, as described above. A material adverse deviation from Fitch guidelines for any key rating driver could cause ratings to be lowered by Fitch.
Certain terms relevant to key VRDP structural protections, including Minimum Asset Coverage and the Effective Leverage Ratio are set forth in the fee agreement relating to the purchase agreement and are renewed on a periodic basis. Any future changes to these terms that weaken the structural protections may have negative rating implications.
The short-term rating assigned to the VRDP Shares of each series may also be sensitive to changes in the financial condition of the liquidity providers. A downgrade of a liquidity provider to 'F2' would result in a downgrade of the short-term ratings of the applicable VRDP Shares to 'F2,' absent other mitigants. A downgrade below 'F2', on the other hand, would not necessarily result in a downgrade of the short-term rating of the applicable VRDP Shares, given the features in the transactions that would result in a mandatory tender of the VRDP Shares for remarketing, or purchase by the liquidity provider in the event of a failed remarketing.
NZF and NVG have the ability to assume economic leverage through derivative transactions which may not be captured by the Minimum Asset Coverage test or Effective Leverage Ratio. NZF and NVG do not currently engage in speculative derivative activities and do not envision engaging in material amounts of such activity in the future. In fact, such activity is limited by the funds' investment guidelines and could run counter to their investment objectives of achieving tax-exempt income. Material speculative derivative exposure in the future could have potential negative rating implications if it adversely affects asset coverage available to rated preferred shares.