Fitch Places Nuveen Fund VRDP Shares' S-T Rng on Positive Wtch on Replacement of Liquidity Providers
OREANDA-NEWS. Fitch Ratings has placed the 'F1' short term rating of the $104,400,000 of the Series 5 Variable Rate Demand Preferred Shares (VRDP Shares) issued by Nuveen California AMT-Free Municipal Income Fund (NKX) on Rating Watch Positive. NKX is a municipal closed-end fund (CEF) managed by Nuveen Fund Advisors, LLC (NFA) and subadvised by Nuveen Asset Management, LLC (NAM).
The placement on Rating Watch Positive is in connection with an expected substitution from the current liquidity provider to the VRDP shares, Morgan Stanley Bank, N.A. (Morgan Stanley: 'A+/F1') to The Toronto-Dominion Bank (TD: 'AA-/F1+'). The terms of the new purchase agreement and fee agreement with TD dated as of April 7, 2016 (effective as of the close of business on May 2, 2016) are expected to be substantially the same as the terms of the agreements being substituted.
The substitution is expected to become effective at the close of business on May 2, 2016. On that date, based on the short-term rating of TD to which the Series 5 VRDP short-term rating would be directly linked, Fitch expects to upgrade the Series 5 VRDP short-term rating to 'F1+' and remove it from Positive Watch. Fitch also expects to affirm the 'AAA' long-term rating assigned to the VRDP Shares, which is not impacted by the liquidity provider substitution.
KEY RATING DRIVERS
The long-term rating primarily reflects:
--Sufficient asset coverage provided to the preferred shares as calculated per the over-collateralization (OC) tests of NKX;
--The structural protections afforded by mandatory de-leveraging provisions in the event of asset coverage declines;
--The legal and regulatory parameters that govern the operations of NKX;
--Both the short- and long-term ratings also reflect the capabilities of NFA as investment advisor and NAM as subadvisor.
The short-term rating primarily reflects:
--The credit strength of the VRDP Shares' current liquidity provider Morgan Stanley ('A+/F1') and the expected post-substitution liquidity provider TD ('AA-/F1+');
--The terms and conditions of the VRDP shares purchase agreements.
NKX is a closed-end management investment company regulated by the Investment Company Act of 1940 (the Act). The fund invests at least 80% of its managed assets in municipal securities that are exempt from regular federal income tax, AMT tax and California state income tax, and may invest up to 20% of assets in below investment grade and/or unrated securities. As of March 31, 2016, NKX had approximately $1.14 billion in total investment exposure.
As of March 31, 2016, NKX's asset coverage ratio for total outstanding preferred shares, as calculated in accordance with the Act, was in excess of the minimum asset coverage of 225% required by the fund's governing documents.
As of the same date, NKX's effective leverage ratios was 32%, which is below the 45% maximum leverage ratio allowed by the fund's governing documents for the VRDP Shares.
In the event of asset coverage declines, NKX's governing documents require the fund to reduce leverage in order to restore compliance with the applicable asset coverage test.
For the VRDP Shares, Minimum Asset Coverage compliance is tested monthly and compliance with the Effective Leverage Ratio is tested daily.
For the 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, NKX will deposit sufficient funds with a third-party tender and paying agent. The time allowed for NKX to restore compliance is consistent with Fitch's 60-business-day criteria guideline.
For VRDP Shares, a breach of the Effective Leverage Ratio is a breach of the fee agreement with the liquidity provider, and at the option of the liquidity provider, may result in mandatory tender of VRDP Shares for remarketing (see the VRDP Purchase Obligation section below for additional details). However, in the event of a breach Fitch expects NKX to redeem a sufficient number of preferred shares or reduce the amount of tender option bonds (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 rating assigned to the VRDP Shares is 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 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 tendered for sale that were not successfully remarketed. The liquidity provider must also purchase all outstanding VRDP Shares if NKX has not obtained an alternate purchase agreement prior to the termination of the purchase agreement being replaced 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 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 weakens the structural protections discussed above may have negative rating implications.
Fitch performed various stress tests on NKX 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 NKX's leverage and portfolio composition migrated to the outer limits of its operating and investment guidelines.
For NKX, only under remote circumstances, such as increasing leverage to 45% while simultaneously increasing its issuer concentration and migrating the portfolios to 80% 'BBB', 10+ years to maturity bonds and 20% high yield bonds, did the asset coverage available to the preferred shares fall below the 'AAA' threshold, and instead passed at an 'AA' rating level.
Given the highly unlikely nature of the stress scenarios and the minimal rating impact, Fitch views NKX's permitted investments, municipal issuer diversification framework and mandatory deleveraging mechanisms as consistent with the present rating levels of the preferred shares.
NFA, a subsidiary of Nuveen Investments, is the investment advisor for NKX. NFA is responsible for the fund's overall investment strategies and their implementation. NAM is a subsidiary of NFA and oversees the day-to-day operations of NKX.
Nuveen Investments and its affiliates had approximately $225 billion in assets under management as of Dec. 31, 2015.
The ratings assigned to the preferred shares may be sensitive to material changes in the leverage level or composition, portfolio credit quality or market risk of NKX, 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 the 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 may also be sensitive to changes in the financial condition of the liquidity provider. If the short-term rating of Morgan Stanley changes before May 2, 2016, the short-term rating of the VRDP shares will change accordingly. If the short-term rating of TD changes before May 2, 2016, the Rating Watch Positive and the expected short-term rating upgrade to 'F1+' as discussed above will likewise change accordingly.
A downgrade of the liquidity provider to 'F2' would result in a downgrade of the short-term rating of the 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 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.
NKX has the ability to assume economic leverage through derivative transactions which may not be captured by the asset coverage test or effective leverage ratio. NKX does not currently engage in speculative derivative activities and does not envision engaging in material amounts of such activity in the future. In fact, such activity is limited by the fund's investment guidelines and could run counter to its investment objectives of achieving tax-exempt income.