SGOV - MUB: For Those In High Tax Brackets Consider This Before The Recession

2023-06-21 14:27:29 ET

Summary

• iShares National Muni Bond ETF provides investors with a low-risk, low-volatility source of income that is free from federal income taxes.
• MUB has a tax-equivalent SEC yield of 5.9%, higher than many other high-paying bond ETFs, offering stability during economic uncertainty.
• With exposure to over 5,000 US muni bonds, I believe MUB offers high yield, low volatility, and capital appreciation opportunities when interest rates fall.

iShares National Muni Bond ETF ( MUB ) offers broad municipal bond market exposure in the US. With AUM of about $32.5B, MUB provides investors with a low-risk and low-volatility source of income that is free from federal income taxes. MUB currently has a 30-day SEC yield of about 3.5%, however, looking at tax-equivalent SEC yield, it has a very impressive yield of almost 6%. Because MUB offers a high-yield, low-risk investment during economic uncertainty, I rate MUB a Buy.

Holdings

MUB holds a whopping 5492 US muni bonds. MUB's top 10 holdings make up only about 2.5% of its AUM.

MUB holds munis in all but 5 states, with California, Florida, and Texas being the top 3 issuers, making up about 48% of the ETF.

Although this may seem like a concentration issue, considering that MUB mostly holds only top-tier rated bonds, there shouldn't be much worry.

Almost all of MUB's holdings are in A-rated bonds or better. The final note on MUB holdings is the maturities of the munis MUB holds.

MUB holds a good mix of maturities. Its largest holding is in 15-20 year munis, followed by 20-25 year munis. These two long-term bonds are then followed by 2 short-term bonds, 0-3 years and 3-6 years. This gives the ETF good diversity among maturity time frames.

Yield

Munis are known for providing a tax-exempt and stable yield to investors. MUB currently has a 30-day SEC yield of about 3.5%. While this may not sound impressive, keep in mind that these yields are tax-exempt. The tax-equivalent SEC yield is a tool for investors to compare tax-exempt yields to taxable yields. MUBS tax-equivalent SEC yield is 5.9%. This yield is higher than many of the highest-paying bond ETFs. The table below shows the 30-day SEC yield of different bond ETFs and the tax-equivalent SEC yield for MUB, so we can compare them.

MUB has a higher yield than all of these other ETFs. As we likely enter a recession in the next 12 or so months, this high yield can bring comfort to investors. Receiving high regular coupons can add stability to a portfolio during the coming recession. Not only does MUB offer this, but it also offers low volatility.

MUB has a tax-equivalent yield of about 5.9%. However, keep in mind that not everyone is taxed the same.

As the image above shows, the highest Federal and State tax rates are assumed. This means that depending on your income and the state you live in, your tax-equivalent yield may be lower than 5.9%. If an investor is in a lower tax bracket and in a state with low or no income tax, the tax-equivalent yield may fall below those of its peers, potentially making them a better option. There are many online calculators to find the tax-equivalent yield in your individual circumstance. Plug your number into the table that was shown in the "Yield" section to see if MUB remains a better option than its peers.

Volatility

Munis are not typically volatile because they aren't very risky. Their default risk is lower than that of investment-grade corporate bonds.

As the chart above illustrates, MUB is less volatile than VTC. It also has a higher tax-equivalent yield. I see no reason to add more volatility to your portfolio in return for a lower yield. But what about ETFs like SGOV and BIL that have practically zero risk and only a slightly lower yield?

MUB vs SGOV and BIL

SGOV and BIL are both ultra-short US treasuries ETFs that pay about 5.1% and 4.9%, respectively. While MUB's tax-equivalent yield is quite a bit higher than these two ETFs, they have very little risk. While I think the larger tax-equivalent yield from MUB alone makes MUB the better option, there is another reason to favor MUB over SGOV and BIL, and that is capital appreciation. Because MUB has longer maturity times and is, therefore, more sensitive to changes in interest rates, it has more capital appreciation potential than SGOV and BIL.

As of right now, we are led to believe by Fed Chairman Powell that there will be two more rate hikes in 2023. We were also told that it will be a couple of years before any rate cuts. But once these cuts start happening, yields will go down, causing bond prices to go up. For short-term treasuries, the capital appreciation from this is going to be minimal. However, as interest rates fall, I think MUB's price will go up.

I want to make the point that SGOV and MUB are not mutually exclusive holdings, especially considering I have given both a Buy rating. It all depends on individual risk tolerance as well as how often an investor wants to make changes to their portfolio. Ideally, an investor would own SGOV or BIL now and switch to MUB just before rates start to fall in order to profit off of capital appreciation, but as the saying goes, "Time in the market always beats timing the market."

Risks

Although munis are considered a safe investment, defaults do still happen, especially when the economy is struggling. In January 2023, first payment defaults doubled year over year. If we enter a recession, as I predict we will, it's likely more munis will default. However, considering that over 80% of MUB is in AAA and AA bonds, I think MUB avoids most of this risk. The 10-year average default rate for AAA-rated munis is 0.00%, while the AA-rated default rate is slightly higher, at 0.02%.

Another potential risk MUB is exposed to is interest rate risk. If inflation doesn't cool as fast as the Fed expects it to, rates may be raised more than expected. This would hurt MUB. Just as MUB will appreciate if rates are cut, if rates rise more than expected, MUB will depreciate.

Conclusion

MUB offers exposure to over 5000 US muni bonds. As we approach the coming recession, I think the high yield and low volatility that MUB offers are very enticing. While there are other ETFs that offer nearly as high of tax-equivalent yields and have even lower risk than MUB, MUB offers capital appreciation opportunities when rates begin to fall. I rate MUB a Buy.

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