2023-06-19 05:48:27 ET
Summary
- The iShares National Muni Bond ETF offers investors an unleveraged and multi-state exposure to generate tax-free income.
- As rate hikes started aggressively in 2022, leveraged options became less attractive, putting passive ETFs back on the radar.
- For those who want a lower risk, lower reward option while protecting against upcoming equity volatility, MUB is a decent bet.
Main Thesis & Background
The purpose of this article is to evaluate the iShares National Muni Bond ETF ( MUB ) as an investment option at its current market price. The fund is managed by BlackRock ( BLK ), and its objective is to "track the investment results of an index composed of investment-grade U.S. municipal bonds". It offers investors an unleveraged and multi-state exposure to generate tax-free income.
As my followers know, this is a sector I have quite diligently but tend to prefer leveraged CEFs (especially those at a discount). But as rate hikes started aggressively in 2022, leveraged options became less attractive. This has put passive ETFs back on the radar - and that story continues today. It has been a while since I covered MUB in particular, but when I last did two years ago I had a modest outlook on it. In hindsight, I was spot-on with that assessment:
Fund Performance (Seeking Alpha)
As I reflect on where the market is headed for the second half of the year, I am starting to see value in munis - as well as other IG bonds in other sectors. But munis can make sense in particular for investors in higher tax brackets and that justifies a bull case for now under the right conditions. Therefore, I will focus on why MUB could be a buy for some individuals in this review.
Is The Income Good Enough? It Depends
To start I will focus on income. This is surely the primary reason why investors look to munis overall. While there can be gains in the underlying securities, the primary purpose of these securities for retail investors is to generate income (in this case monthly) that is exempt from many - and sometimes all - federal, state, and local taxes. In this sense, while the yield of just over 3% may not look too attractive on the surface, it can rise substantially for investors who have an above-average tax burden:
Current Yields (iShares)
What I see here is that investors who will benefit from the tax-exempt status the most have a lot of merit in buying into funds like MUB. A yield near 6% (after tax considerations) in this environment is not a bad deal.
By contrast, if your tax burden is low (or non-existent) then the buy case here is difficult to make. A 3% distribution yield isn't that great with inflation where it is. While there is the potential for additional gains if the underlying securities rise in value - that will be difficult if interest rates keep rising. Further, one can obtain yields in the 4-5% range at many banks through savings accounts and CDs. Again, the upside in a fund like MUB could be higher if the securities rise, but the opposite is also true if they fall. This would make a deposit account more attractive by comparison.
What this tells me is that investors really need to understand their own need for income, outlook for muni bond prices, and tax status. Only then can the analysis of this yield have any specific value.
Fortunately, there is one development from last year that all investors can relish in a bit. This is the amount of distribution annualized growth:
Feb - June Distributions 2022 | Feb - June Distributions 2023 | YOY Change |
$.83/share | $1.16/share | 40% |
Source: iShares
The takeaway for me is this is something everyone can find assuring. The income stream is up - and in a big way - on a year-over-year basis. So even if the actual yield is not quite as high as one would like, this is still a positive attribute that supports a more positive outlook.
Why Munis? Equity Bullishness A Concern
Looking at the broader macro-environment, there are plenty of reasons for considering equity hedges. Munis are a definitive hedge - as are bonds in general. So when one is concerned about the state of the equity market, looking to the municipal bond sector makes a lot of sense. This is true for MUB, and for the plethora of ways to play this space.
This leads to the question - why would one be concerned about equities right now? After all, there is a lot of momentum on their side and year-to-date performance for the major U.S. indices has been terrific. This momentum has been clear in the short term, with the S&P 500 rising for five weeks straight:
S&P 500 (Weekly) Performance (Bloomberg)
This is where the subjectivity comes in. This is a great run to be sure. As someone who is a long-only equity investor, I welcome gains like this and I hope they continue. But "hope" isn't the best investment strategy. When I see such consistent gains I begin to take a contrarian mindset. We should all know by now that stocks do not go up forever. We also haven't seen five straight weeks of gains for the S&P 500 since 2021 - so that makes me cautious.
Add to this my list of concerns is that individual investors are viewing recent gains with a wave of optimism. After being mostly pessimistic in 2022, the "bullishness" indicator has soared of late. This coincides with the stock gains we have seen in the short term:
Bullish Sentiment (American Association of Individual Investors)
The simple conclusion for me is that average investors are getting bullish at just the wrong time. Stocks have been rising for weeks and are looking overbought to me. Yet, investors are now starting to jump on the bandwagon. While that could push equities higher still, I have concerns, and the contrarian alarm bells are ringing loudly. This tells me that giving equity hedges - such as municipal bonds - some consideration makes a lot of sense at the moment.
Inflation Still A Thorn, Despite The Declines
I have laid out a couple of key reasons for owning munis going forward. And I stand by that rationale. But it would be naive to think there isn't any risk to this strategy. Continued equity gains are certainly one (hedging can be painful if what you are hedging against keeps going up!). Further, we have to remember that MUB hasn't exactly been a darling investment of late. As the opening paragraph showed, this fund didn't deliver much of anything in the last two-year period. So anticipating robust gains going forward is probably not realistic.
With this in mind, we should examine one of the fundamental reasons why MUB hasn't done very well. The primary thought is inflation. While MUB is not the most interest rate-sensitive investment, its duration of just above six years should illustrate why it has had a tough time as interest rates have risen:
MUB's Duration (iShares)
What this means is that if the Fed keeps on raising rates - which it has indicated it may do - then MUB is going to see some pressure. That has been true for most of 2022 and has been a challenge this year as well.
The issue going forward is inflation is still top of mind for a good reason. Fortunately, year-over-year (and month-over-month) increases have declined. So consumers are getting some relief, and business too. But the other side of the coin is that inflation remains elevated on a historical level. Price increases continue and while they are slowing, they are still high enough to pressure both the consumer outlook and increase the possibility for more Fed hikes:
The progress here is notable and welcome. But the perspective should be we aren't out of the woods yet. Inflation remains an ever-present hurdle to the global economy. We only need to look back a year to 2022 to see how inflation can drive both stocks and bonds lower. While 2023 has been a nice reversal, this macro-headwind still exists and should be weighed carefully.
Be Aware Of Concentration Risk
My final point is not really a "good" or "bad" one, but rather something to be aware of. The fact is that New York and California issues dominate the municipal bond market. That has been the case for a long time, and it is relevant today. There is strong appetite from investors in those jurisdiction for tax-exempt income due to the higher-than-average taxation in those states (and localities). As a result, those state and city governments tap the muni bond market more than others. In addition, due to their size, they simply play a very large role in this sector.
I am not taking a position on whether this is favorable or not - it depends on each investor's outlook and need for tax exemption in those states. But the fact is that many active fund managers that run muni bond funds will take a more proactive approach to limit their funds from getting over-exposed to any one area. This includes sector themes and, of course, states. But contrast, MUB is a passive ETF that simply tracks the broader muni index. This means the fund managers do not have the same active objective or discretion to remove what ends up being a fairly high concentration to both NY and Cali:
MUB's State Exposure (iShares)
Whether or not this matters is dependent on each person's unique situation. But this is concentration risk whether we like it or not. That isn't necessarily a reason to avoid owning something. Perhaps a fund is concentrated in areas that disproportionately benefit you - such as residents of either New York or California. Or perhaps one has a particularly bullish outlook for muni bonds out of those jurisdictions. Both of these attributes suggest owning a fund like MUB would be a wise move then.
But the opposite is also true. If you are a resident of one of the other 48 states, does it really make sense to load up a fund that is dominated by bonds from New York or Cali. Perhaps not. Especially since headlines of outward migration and loss of tax revenue from both of these state economies seems to be a persistent theme:
In summary, make sure you understand the risks associated with being heavily concentrated in just a handful of states before deciding to buy MUB.
Bottom-line
MUB has seen a reasonable gain so far in 2023 and more of that could be on the way. As equities get increasingly frothy and inflation cools off a bit, muni bonds are growing in attractiveness.
There are risks to this thesis. Unleveraged funds like MUB are rarely strong winners, so expecting modest gains is likely the best one can hope for. Further, the amount of concentration risk in states like New York and California may mean this fund is not suitable for everyone.
But I still see a buy case here for the right individual. Bonds as a whole having above-average yields on a historic basis and a Fed pause, coupled with declining inflation figures, are starting to bring buyers back in. Therefore, I believe MUB could be a reasonable equity hedge going forward and that a rating upgrade to "buy" is warranted at this time.
For further details see:
MUB: Muni Bonds Still A Reasonable Alternative (Upgrade To Buy)