MUB: National Munis Face Covid Pressures, But The Market Ignores Them

ETFS

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. Munis continue to push higher through 2020, and MUB has registered a modest gain since my last review. With bullish momentum, it would be easy to expect further gains to continue. However, I am maintaining a more cautious outlook on the sector, and passive ETFs like MUB, for a few reasons. One, yields have fallen dramatically, which has reduced the distribution level offered by MUB by a significant amount. Two, the fiscal realities of state and local governments are quite poor. The pandemic has shuttered businesses, forced people out of work, and pressured tax receipts. Despite these pressures, the muni market is rallying as if there is no risk to the sector. Three, the market is ignoring the macro risks facing munis because they are expecting forthcoming support from Washington. While the Fed has acted, aid talks in Congress have stalled. When Congress comes back into session in September, a comprehensive bill could be passed, but I am not counting on that happening anytime soon.

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 $115.88/share and yields 2.26% annually. I reviewed MUB back in May, after recommending it in March. Despite bullish momentum leading into that review, I downgraded my outlook to neutral because I felt the market was getting a bit ahead of itself. In hindsight, this was a reasonable call, although MUB has continued to register positive returns since that time:

Source: Seeking Alpha

With the broader market continuing to defy gravity, I am reviewing the funds and sectors I cover to see if I should change any ratings going forward. After review, while munis will remain a core holding in my portfolio, I believe a neutral rating remains appropriate, and I will explain why below.

Yields Are Dropping: Why That Is A Problem – Part 1

To begin, I want to touch on the broader investment landscape for munis, with specific attention to current yields. Clearly, yield is one of the primary considerations for fixed-income investors, which has made the past decade extremely challenging. While muni yields have been quite low, there has been relative value in them in the short term, especially for investors in higher tax brackets. This is because yields are down across the investment grade space, whether in Treasuries, corporates, or munis. However, munis have the added benefit of being tax-exempt, so the after-tax yield of many of these bonds exceeds their Treasury or corporate counterparts.

While this tax-exempt story remains intact, investors have to recognize the limitations of this benefit when yields drop. With MUB yielding just over 2%, the tax-exempt status, while still nice to have, is not overwhelming by any stretch of imagination. Further, yields do not appear ready to rise anytime soon, as they have actually been declining quite sharply across the broader sector. To illustrate, consider the graphs below. They show muni yields are sitting at historic lows across short-term and longer-term debt:

Source: Bloomberg

Of course, this sector is not alone in this phenomenon. As I noted, yields are down across the board, so this is reflective of macro conditions and not something that is happening solely in the muni sector. But it is important to recognize the impact on funds like MUB. With a yield just over 2%, the income is not very generous, even on an after-tax basis. Further, the decline of yields on the open market has allowed new issues to offer very low yields. This means funds like MUB are picking up new holdings with historically low yields, pressuring the fund’s ability to offer a competitive distribution. In fact, MUB’s latest distribution shows a marked drop over time, as seen below:

7/20 Distribution 8/20 Distribution % Change
$.206/share $.194/share (6%)
2/20 Distribution 8/20 Distribution
$.215/share $.194/share (10%)
8/19 Distribution 8/20 Distribution
$.226/share $.194/share (14%)

Source: iShares

My point here is simple – the declining yields across the muni sector are taking its toll on what MUB is able to deliver in distributions. The pace of the income drop is not entirely comforting, with a double-digit decline year over year and a 6% drop since last month as well. Ultimately, this reality is consistent with most of the fixed-income market, but it does limit the total return potential for MUB going forward.

Dropping Yields – Part 2

As I noted, I view declining yields as a headwind for the muni sector because, naturally, I want to obtain the highest yield I can find while staying within my risk tolerance. However, aside from the obvious fact that a lower yield is less attractive, my second concern expands on this point. Specifically, it is not so much that yields are low in isolation, it is the fact that they are declining when I see the macro-picture worsening. What I mean by this is state and local governments have come under enormous pressure in 2020. As the Covid-19 pandemic shut down economies across the globe, tax revenues dried up. These governments are reliant on income taxes, sales taxes, and property taxes to run their operations and provide services. With millions out of work and retail businesses shut down, income and sales taxes faced steep declines. Further, the challenges on the hospital and other health systems required government support, adding stress on already strained budgets.

My point here is, even in isolation, declining yields make a sector less attractive. But when we consider yields have declined during a unique period of turmoil, we have to question whether investors are adequately pricing the risk associated with these products. Yes, munis have a strong historical track record, and I do not believe widespread defaults are going to occur. But the market seems a bit out of balance. For example, even New York City, the original epicenter of the crisis in America, yields are sitting near their lowest levels in years, as shown below:

Source: Bloomberg

My takeaway is this market does not make a whole lot of sense. Local and state finances have deteriorated, yet investors are demanding even less compensation to own the bonds backed by these state and local governments than they did at the end of 2019 before the pandemic hit. The market seems to expect very little trouble from this sector in the months ahead. While I generally agree that munis are resilient and will survive this crisis, I am likewise leery of paying record prices for them during a pandemic. This outlook supports my neutral view on the sector as a whole.

So Why Buy Munis? Negative Correlation With Equities

Through this review, my tone has generally sounded negative. Yet, I must emphasize that I am not bearish on this sector, but rather expect modest positive gains by year-end. In the case of MUB, which is a non-leveraged, passive ETF, this means maybe 1-2% over the next four months. Therefore, investors may be asking, given the risks I highlighted above, how can I justify this view, and why would any investor want to buy into munis now?

Those are fair questions, and the primary answer rests with munis’ relation to equities. Specifically, munis are negatively correlated to U.S. equities and tend to rise when the broader equity market falls. This is common among many fixed-income classes, especially in the investment-grade space. And this is where MUB does reside, as it exclusively holds debt rated BBB or better:

Source: iShares

Therefore, investors like myself, who feel that equities may be due for a bit of a correction, may want to consider munis as a relative hedge. While equities clearly have plenty of bullish momentum, my concern with the broader indices is similar to my concern with where muni yields sit. The Dow, S&P 500, and the NASDAQ are all back in record territory, yet the broader economy is struggling from high unemployment, partial lockdowns, and rising delinquencies in mortgage debt. As such, I am only building on to equity positions with a very selective mindset and am focusing the bulk of my cash on equity hedges, such as gold, corporate bonds, and munis.

The reason for this is straight forward. I expect equities will take a breather soon and, if they do, munis have a track record of rising during those time periods. In fact, during months where the S&P 500 posts modest declines, the broader muni market tends to rise, as shown below:

Source: Advisor Perspectives

My takeaway is, if investors expect volatility ahead, munis may still be a decent play to hide out in the short term.

Of course, investors may be considering just moving to cash rather than taking on any risk at all, given the challenging environment we find ourselves in. While this is certainly an option, I would point out that cash balances are already at record high levels. Even as equities have rallied strongly, the value of cash in money market funds has grown well beyond its historical range:

Source: Yahoo Finance

I view this reality as support that munis may hold up reasonably well. With so much cash already on hand, I don’t see investors adding much to their cash positions anymore. Further, those that feel they now want to put this cash to work, but are reluctant to pump more into equities given the current levels, may consider munis. Therefore, I see demand potential for MUB despite the headwinds. This demand could come in particular from investors who are looking to invest their current cash hoard, or from working professionals (like myself) who earn fresh cash each month that has to go to work somewhere. Ultimately, munis have served as a reliable hedge over time, and that story could certainly continue as we finish out 2020.

Is The Market Overestimating Federal Support?

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 (Facility), which is used to purchase short-term notes directly from states. This announcement was a win for the sector and helps explain the sharp rebound in demand coming off the March lows.

However, up to this point, most municipalities have not utilized this facility, but have opted to continue to raise new issuance on the open market because they are able to find such attractive yields there. Thus, munis have seen surging investor demand due to the Fed’s willingness to help, but not the actual help itself. With the exception of Illinois, no state has tapped the Facility, and even New York City has limited the use of this stimulus measure, with only the Metropolitan Transportation Authority considering it.

With this in mind, it is worth examining why munis have performed so well, when Fed support has actually been quite limited. Investors were encouraged by the Fed’s announcement, but actual market activity has not shown a willingness of municipalities to use it. Yet, investors have driven yields down to multi-year lows, so why is that the case? The answer lies in expected future support, as many investors do not expect the Fed or Congress to let municipalities default on their obligations. Thus, despite limited federal help to date, investors anticipate more will come in the future, if required. The market essentially sees the risk to munis as very minimal due to this implied back-stop, which explains the rock-bottom yields despite a difficult environment.

With this understanding, I want to again exert a word of caution. The market seems extremely confident in the government’s willingness, and ability, to prevent widespread muni defaults, but this confidence may be a red flag. While munis’ track record speaks for itself in terms of very low defaults in the investment-grade sector, the Covid-19 pandemic is a very unique circumstance that could pressure the sector in ways we have not seen before. Further, President Trump and the Republican-led Senate do not seem keen to offer large-scale support for munis at this time. While this could change if the situation on the ground deteriorates, for now, I have to base my outlook on their current stance. To understand why, consider that Senate Republicans have recently rejected a comprehensive aid bill to assist state and local governments, as reported by Bloomberg. While the plan put forth by Republican lawmakers did include $105 billion for schools and $16 billion in grants to states for coronavirus testing, they rejected the “no string attached” aid, which they see as bailing out “poorly run” states and cities. With Congress adjourning in August, there has not been any progress since that rejection.

This stance by Senate Republicans is echoed by President Trump, so Democratic proposals to send up to $1 trillion in aid to local and state governments are not anywhere close to getting passed. In explaining his opposition to the bill, President Trump was quoted:

“It’s a shame to reward badly run radical left Democrats with all of this money they’re looking for.”

Source: Associated Press

My point here is not to argue for or against these particular proposals or support packages. Rather, I am just explaining the reality that the two sides in Congress seem far apart in terms of their objectives and how much they want to spend. The muni market appears to be counting on forthcoming federal support to justify pricing new issuance at record low prices. My take would be this justification may be overly optimistic.

Bottom Line

MUB remains a valid equity hedge, but investors need to manage expectations from here. With a return to its pre-crisis price, a declining yield, and a challenging macro outlook, MUB’s upside is limited. While munis should remain in favor, especially among those in high tax brackets, the total return offered by passive funds in the space will likely be in the very low single digits heading into 2021. The finances of state and local governments are in a tough spot, and federal support is not a foregone conclusion. Therefore, I believe the neutral rating for MUB remains appropriate, and I encourage investors to be very selective on starting new positions at this time.

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.

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