New Fitch Muni Bond Rating Method Spotlights Three Nuveen Preferred Funds

The world of municipal bonds, issued by state and local governments, intersects the world of preferred stocks on the doorstep of an outfit called Nuveen Investments out of Chicago.

Nuveen bundles municipal bonds into a fund (similar to a mutual fund) then sells shares of the fund to the investing public in the form of preferred stock shares.

As long as the government entity pays interest on the bonds to the fund, the fund is able to pay the dividends to its preferred stock shareholders.

Yesterday Fitch announced that it is changing the way it rates state and local pension funds. These values are used in turn for Fitch’s ratings of bonds issued by these government entities.

For preferred stock investors who own preferred stock shares in Nuveen’s funds that are backed by bonds from these governments, Fitch’s new formula could become meaningful especially if you are intending on selling your shares prior to maturity.

Illinois and California have become synonymous of bad financial management. In the Illinois case the state not only borrows the cash needed to fund about half of its annual budget (i.e. it spends about twice as much as it generates), but it now has to route 12 percent of its funds to offset pension costs (which is chronically underfunded).

Many local governments are in the same boat. Miami, Florida puts a full quarter of its operating budget toward paying its pension obligations.

As described in yesterday’s announcement, Fitch is now going to use an annual average return of 7% when valuing these state and local government pension funds (rather than the 8+% used by most funds). That lowers the future value (assets) of the fund.

Fitch defines a pension fund to be “weak” if its assets fall below 60 percent of its liabilities. Since the state of Illinois has set its average annual pension fund return at 8.5%, Fitch’s new 7% assumption drops the State Employees Retirement System pension fund value from 44% to 37% (Illinois, along with California, was already in “weak” territory before the change from Fitch).

While the new 7% assumption does not push any states into the weak category, the following seven states are getting very close to that mark: Montana, Hawaii, Vermont, New Jersey, Nevada, Massachusetts and Minnesota.

Nuveen offers preferred stock funds backed by bonds from two of these seven states:

* NUJ-C, Nuveen New Jersey Dividend Advantage Municipal Fund 2 (maturity 11/01/15)
* NGX-C, Nuveen Insured Massachusetts Tax-Free Adv Muni Fund (maturity 03/01/15)

While no Nuveen preferred stock fund is backed by Illinois bonds, there is a California bond-backed Nuveen fund:

* NVX-C, Nuveen California Dividend Advantage Municipal Fund 2 (maturity 11/01/15)

Preferred stock investors who hold shares of NUJ-C, NGX-C or NVX-C should keep a close eye on the Fitch ratings of bonds issued by New Jersey, Massachusetts and California. In the event that Fitch’s new appraisal method affects the market prices of Nuveen’s funds, these three Nuveen preferred stock funds will likely be among the first.

Many Happy Returns.