Via SeekingAlpha.com

Main Thesis

The purpose of this article is to evaluate the iShares National Muni Bond ETF (NYSEARCA:MUB) as an investment option at its current market price. MUB has performed extremely well in the short-term, and that performance could continue if state re-openings go as planned, interest rates remain low, and Fed support for the sector drives up asset prices. However, there are reasons for caution as well. While Fed support has helped the sector rebound sharply, the reality is local and state revenues have declined enormously since the Covid-19 pandemic started. This will challenge the ability of the issuers to make good on their obligations to bond holders, increasing default risk. The good news is investment-grade muni bonds have a tremendous track record of steady income and low defaults, which should put investors’ minds at ease. But the challenge is we are in an unprecedented time, and historical norms are going to be put to the test. Therefore, I see valid reasons for holding on to MUB, but to have a more modest outlook for total return potential going forward.

Background

First, a little about MUB. The fund is managed by BlackRock, and its objective is to “track the investment results of an index composed of investment-grade U.S. municipal bonds”. MUB currently trades at $113.49/share and yields 2.38% annually. I covered MUB for the first time in March, when I viewed the sharp market sell-off as a time to pick up quality funds at a discount. While MUB is a passive ETF, it had been taking an unjustified beating, in my view. As such, I recommended investors start positions, and that call turns out to have been well justified based on its short-term performance:

Source: Seeking Alpha

While the broader market has rallied, seeing a passive and stable fund like MUB return almost 10% in less than two months is quite surprising. Given the sharpness of this gain, I figured it was time to take another look at the fund, to see if I should change my rating going forward. After review, while I see plenty of merit to continuing to hold MUB, I now see less upside, forcing me to downgrade my outlook to “neutral”, and I will explain why below.

The Hunt For Yield Will Continue

To begin, I want to touch on the broader investment landscape, and how it relates to fixed-income. Clearly, equity markets have been rallying recently. This comes on the backdrop of fiscal stimulus measures, as well as optimism over the early stages of the re-opening of economies worldwide. However, I believe fixed-income sectors will provide a very important hedge for retail investors going forward. While equity markets will surely outperform if re-openings go well, I foresee challenges on the horizon, in terms of recovering to pre-crisis levels of employment, business investment, and consumer confidence. As such, I believe investment-grade, fixed-income sectors will provide a steady level of income and an important equity hedge.

A key reason for this thesis is that most of the developed world currently has interest rates near zero, or even below zero, as we see in the graph below:

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Source: Bloomberg

This reality has investors starved for quality income streams, as government bonds are not offering much. While investors have many options to choose from, I am preferring quality right now, as the economic outlook is just too uncertain for my taste. However, even within the investment-grade bond space, investors have options, so choosing munis is not an automatic decision. But I see a very valid argument for buying munis over comparable corporates at the moment, and I will dive into the details why in the next paragraph.

Investment-Grade Munis Have An Attractive Value Proposition

To understand why I continue to like MUB, let us take a look at the income offered by the fund compared to investment-grade corporate bonds. While MUB’s stated yield is just over 2%, its after-tax yield is actually more competitive than corporates for investors in the highest tax bracket. To illustrate, consider the graph below, which shows the underlying indexes for both MUB and the investment-grade corporate bond sector:

Source: S&P Global

As you can see, when we look at the tax equivalent yield of the muni index, it actually exceeds the investment-grade corporate bond index, if we assume a 35% tax rate. This spread has occurred because while investment-grade corporates have seen their yields come down in the short-term due to robust demand, the same cannot be said for munis. The muni market has come under some pressure lately, as investors come to terms with the reality of lower revenues across the space. However, I believe the fear over muni defaults is overdone, as the sector has a strong track record of low defaults and it now has Fed support. Therefore, I see this as an opportunity to pick up munis for relative value compared to their corporate counterparts. Furthermore, if we look at the underlying credit quality of the two indexes, we actually see munis are quite a bit stronger.

To illustrate, the graph below takes the standard indexes of both the investment-grade muni and corporate bond markets. While corporate bonds are heavily tilted towards the lower end of the rating spectrum, muni bonds show the opposite, with the majority in the upper tranches:

Source: S&P Global

My takeaway here is this presents investors in munis with a bit of a win-win. The after-tax yield is higher, and the underlying credit quality is stronger. While I could see the argument to buying into either sector, munis clearly have the edge in my view.

Strong Historical Track Record For Munis

Of course, investors may still feel the muni market is just too risky given the current climate, and feel the investment-grade ratings may not accurately reflect the risk being taken. While I acknowledge that this is going to be a very challenging few quarters, for corporations and municipalities, it is important to remember the historical record for investment-grade munis is very impressive. This pandemic certainly has the world on edge, but the muni bond sector has been through challenges before, and the last 50 years tell us the sector is very resilient. To understand why, let us take a look at the default rate for both the U.S. muni bond and global corporate bond sectors, as shown below:

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Source: Lord Abbett

This graph shows us that for both sectors defaults have been historically quite rare, at least in the investment-grade space. In fairness, the default rate for U.S. investment-grade corporates is even stronger than the global rate, but muni bonds still win out over both U.S. and global corporates in the end. The default rate in the A-rated category is essentially non-existent over the past 50 years, and that should give investors plenty of comfort.

And this story is relevant for MUB, as the fund almost exclusively holds investment-grade debt, with the vast majority rated A or better, shown below:

Source: iShares

My takeaway here is MUB is made up of rock-solid assets with very strong credit ratings and a track record of very few defaults. While the fund is not going to make you rich, it appears to continue to be a good option for those looking to preserve their wealth, while obtaining tax-free income.

Entry Point Not As Attractive Now As It Was In March

Up to this point, my tone in this review has been quite positive. However, I did note at the beginning of the article that I was downgrading my outlook for MUB. I do feel the fund remains a reasonable equity hedge, but I want to set the expectation that the gains MUB has seen recently (10% in two months) are unlikely to continue. One of the primary reasons for this change in outlook is the fund’s valuation. As a passive ETF, MUB typically trades right around its NAV. However, during the March sell-off, investors dumped all types of assets across the fixed-income spectrum, including investment-grade munis. As a result, MUB traded at a discounted market price of 5.5% to its NAV. As the fund sharply rebounded, this discount evaporated, and now MUB trades at a slight premium, as shown below:

Source: iShares

The point to emphasize here is the “easy money” has been made. Investors who were willing to dive in at the height of the panic have done well. While there is certainly a case to hold and/or buy MUB right now, investors should manage their expectations on how much upside is left. I see the fund providing stable, tax-free income, but see limited upside for the share price. This will limit total return and justifies my more neutral outlook.

Fed Could Be A Tailwind, Is It Enough?

My final point concerns government support for the muni sector. As I noted in my last review, the Fed surprised markets when it announced it was expanding its support efforts to include muni bonds. This effort established the Municipal Liquidity Facility, which will be used purchase up to $500 billion of short-term notes directly from U.S. states.

This announcement was a big win for the sector when it came out, as it saw muni bond prices rebound and it restored both confidence and liquidity into the sector. However, the need for the program underscores just how difficult the environment is. With stock lock-downs still in place in most of the country, sales tax revenues have been badly hit. Further, with millions unemployed, state income taxes are sure to decline as well. Also importantly, many revenue bonds which rely on travelers, such as airports, public transit systems, and toll roads, are not collecting duties, making the bonds that back those projects susceptible to default. In summary, the macro-environment is very challenging right now, and while investors have indeed bid prices on munis back up, it is unclear at this time if the Fed support will ultimately be enough.

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My view is we have to take a bit of a “wait and see” approach, and that is another reason for my decline in optimism. The Fed’s support is sure to have a positive impact, and as states do begin to re-open, we could be pleasantly surprised by the outcomes, leading more states to follow. Further, the Fed started buying corporate bond ETFs last week, which provided a boost to the sector. This buying could eventually spread to muni ETFs, and MUB would likely be a direct beneficiary of these actions. Therefore, even if investors are concerned about the risk profile of munis, they may want to front-run potential Fed buying to capture price gains that way. Ultimately, the headwinds and tailwinds for MUB present a mixed future, justifying my neutral stance.

Bottom Line

MUB remains a valid equity hedge, but further upside will be difficult to come by. The low interest rate world encourages investors to look to fixed-income sectors within the U.S., and the fact that investment-grade munis have a higher tax equivalent yield than investment grade corporates is a tailwind. However, MUB has seen its buy-in price rise by almost 6% in terms of premium to NAV since my last review. This means investors who bought in during the panic have done well, but it limits the potential for price appreciation in the months ahead. Finally, while Fed support for the sector is a positive catalyst, we do not know for sure yet how it will ultimately play out, as the action is unprecedented. With all the challenges facing municipalities right now, Fed action may not be enough to save the whole sector from some level of default. Therefore, I believe a neutral rating on MUB is justified for the time being, and encourage investors to be very selective on any new positions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.