Besides Obvious Duration Risks, MUB Also Has State Tax Risks

The iShares National Muni Bond ETF (NYSEARCA:MUB) is a way to get some fixed income exposure and yield in the current market. Coupons are high in this ETF and the YTMs are higher than what you’d expect from bonds of similar risk, hinting at a liquidity discount on municipal bonds. Durations are somewhat long which makes the timing bad for an ETF like this, and also tax-backed bonds might receive risk premiums on the basis of work from home risking certain business’ centers tax revenues. Credit risk is still minimal, and for the rating the yields are good as of now. But rising rates means there is going to be downside from here on out. A pass on the basis of market moment.

MUB Breakdown

The MUB contains high credit quality municipal bonds. The vast majority of the portfolio is AA rated or better (80%). The opportunity for a fixed yield here is quite high. Coupons for the bonds average close to 5%, and on a tax adjusted basis, the bonds yield well at about 4.3%. Most of the bonds are state-tax backed (37%) in geographies like New York and California.

Maturities are generally pretty long. While quite uniformly distributed across maturities, there are lots of 20-25 year bonds. Offsetting that is a concentration of maturities coming within the next 3-6 years. The weighted average duration is 5 years.

Remarks

The YTMs on the municipal bonds are quite surprising. They are tax exempt, so we’ve adjusted the YTMs to be able to compare with yields from corporate bonds. With a much better credit profile, the municipal bonds in the MUB yield only very slightly less than corporate bonds. Current reference rates are about 2% risk-free, which means a 2% additional premium in muni bonds with almost no additional credit risk.

While attractive, that doesn’t mean that it’s necessarily an advisable investment. Relative to a corporate bond ETF with a similar duration, it would be relatively wise, especially since the costs of a muni bond ETF and a corporate bond ETF are similar despite muni bonds being a much less liquid and modern market. Indeed, this might be why they yield relatively better: liquidity discounts. So the MUB ETF offers that value add with costs only being 0.07%, which is on the very low end of ETFs. But the issue of duration still stands when we know that reference rates are coming up higher as the Fed continues to signal that inflation must be fought and rates must rise even further. A 5 year duration means 5x sensitivity in price to unit hikes in rates to the downside. The timing continues to be bad for any bonds with longer durations.

While more minor, investors should also be aware of the remote risk that credit risk premiums could rise for states like California and New York. California is dealing with an exodus problem, and the loss in tax revenues that could occur for places like New York would be enormous. Work from home is a threat to these states’ coffers, which is why companies are pushing aggressively for return to office because they know that stakeholders will complain. It could affect the credit ratings of these bonds were these issues to start bearing on state finances with more permanent outlooks.

But the key issue isn’t credit risk, it’s duration. We pass on anything that’s sensitive to rate hikes, simple as that.

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