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MUB: Is This Large ETF A Safe Haven During Rising Rates?

Summary This is the largest muni ETF in the marketplace with a tremendous amount of institutional assets. Will they stay put with rising rates? What is the exposure for the long end of the yield curve and various states? We answer these questions and provide our recommendation on whether it is worth the risk. The iShares National AMT-Free Muni Bond ETF, MUB , is the largest muni ETF in the marketplace. Since the beginning of the year over $700 million in new assets have been added. With all of the bonds rated investment grade or equivalent, we decided to analyze this ETF to determine if it would be a safe haven, if and when interest rates move higher. We also wanted to determine what exposure there is to recent public pension problems in states such as Illinois and New Jersey. With 2,748 holdings this ETF is a comprehensive ETF. According to the fund’s sponsor BlackRock (NYSE: BLK ): The iShares National AMT-Free Muni ETF seeks to track the investment results of an index composed of investment-grade U.S. bonds. The index Blackrock is referring to is the S&P National AMT-Free Municipal Bond Index or {SPMUNUST}. Currently the index has 10,310 issues versus the 2,748 in the ETF, as mentioned above. U.S. territories, including Puerto Rico are excluded from the index. The index is rebalanced monthly and the fund is rebalanced on a monthly basis as well. With such a large quantity difference between the index and ETF the indexing strategy of “Representative sampling” is the most appropriate here. According to the prospectus, this involves simply investing in a representative sample of securities that collectively has an investment profile similar to that of the underlying index. According to S&P, the overall index is designed to track the larger more liquid bonds in the marketplace. Investment grade general obligation, (GO) and essential purpose revenue bonds are included, while high yield bonds are excluded. In terms of a breakdown of the credit quality of the ETF it is not as simple as our past analysis. In most of our previous analysis we would go over each and every issue in an ETF and break down the credit quality and weight the ratings for both S&P and Moody’s. Unfortunately, with over 2,700 issues we decided to defer to the sponsor. iShares by Blackrock uses ratings from S&P, Moody’s and Fitch and converts them to the equivalent S&P major rating category. MUB Credit Quality S&P Ratings&Equivalent Weight Cash and/or Derivatives 0.33% AAA Rated 21.47% AA Rated 56.86% A Rated 20.05% BBB Rated 1.29% According to Morningstar , they cite a .04% in BB rated debt as of June 30, while Fidelity cites .02% in high yield, as of July 20. We attribute these small figures in the below investment grade category to a few recent downgraded and split credit ratings. As such, we can categorically state that the underlying holdings are higher investment grade issues and as noted, almost 25% are AAA rated. Our first point of analysis was the sectors of the ETF. We needed to examine which sectors of the ETF represent exposure in the marketplace. We were expecting only a small divergence between informational sources. What we found was a little confusing. iShares breakdown is quite broad based, while Morningstar is narrower in scope. We elected to use Morningstar’s sector weightings. Sectors of MUB holdings Sector Weight State and Local General Obligation (GO) 31.81% Transportation 23.31% Education 13.39% Water & Sewer 10.68% Advance Refunded or Escrow 8.67% Utilities 5.32% Industrial 1.65% Health 0.06% Housing 0.05% While Morningstar’s breakdown seems thorough it is confusing when compared to iShares. iShares uses: State Tax-Backed: 39.49%, Utility (which makes sense in aggregate with water & sewer): 16.56%, Transportation: 14.82%, Local Tax-Backed: 10.91%, Pre-refunded/Escrow (almost in agreement):8.96%, School Districts: 5.26%, Education: 3.11% and Other Utilities: .52%. As such, in any event the sector risks here are limited to only industrial and health. The primary reasons are the GO’s are backed by the full faith and credit (i.e. taxes), while the “WET” (water, electricity and transportation) are backed by fees and are unlikely to be terminated at any cost. The not so recent Detroit Ch. 9 bankruptcy is a key example of this facet of “WET” issues. The municipality continued to provide these essential services after filing for Chapter 9. The advanced refunded or escrow bonds at 8.67% are AAA and backed by US treasuries (actually, what are termed “slugs”) and are not an issue whatsoever. In terms of the maturity breakdown there is a divergence again in information from iShares and other providers. In this case, we strictly use iShares information. The main reasons is that iShares uses a “Weighted Average Life” or WAL to determine their average length of time to repayment of principal for the securities in the ETF. They use this metric due to the fact that many, if not all, of the high coupon bonds in the ETF will be called. The other information providers do not consider it. MUB Maturity breakdown (WAL) Maturity Weight Cash and/or Derivatives 0.64 0-3 years 19.40 3-6 years 12.71 6-8 years 7.18 8-10 years 5.96 10-12 years 5.98 12-15 years 7.83 15-20 years 13.24 20-25 years 14.04 25+ years 13.03 Morningstar states the maturities using actual dates with a different scale as well. As such an actual comparison is difficult on almost all categories. For information here are Morningstar’s maturity breakdown: 1-3 years: 8.71%, 3-5 years: 8.69%, 5-7 years: 8.67%, 7-10 years: 10.84%, 10-15 years: 16.45%, 15-20 years: 16.21%, 20-30 years: 26.71%, and over 30 years: 3.71%. Fidelity’s maturity breakdown is far simpler: Short Term: 12.65%, Intermediate Term: 26.90%, and Long Term: 60.17%. We interpret the WAL structure from iShares as what is termed a “barbell approach” with heavy weighting on the short end, in terms of callable and pre-refunded issues and a good sized weighting on the long end to take advantage of the higher coupons in term bonds. A key determinant here is of course, not just maturity but duration. We will examine this shortly after reviewing the top 15 issues and their geographic locations. For information purposes here are the top 15 issues with description, coupon and maturity, ratings (Moody’s and S&P), duration, modified duration and yield to the worst and the underlying weight in the ETF: MUB top 15 holdings Unlike many other ETFs, (in terms of its top 15 weightings) the top 15 holdings represent only 3.986% and the balance of 2,736 holdings and negative (settlement) cash balance represents 96.034%. No holdings here represent even .50%, excluding the AAA rated muni money market fund sponsored by Blackrock. As such, we can categorically state this ETF is as close to a full spectrum of diverse issues. In terms of exposure in terms of maturity or duration, it is clear that if rates do go higher the value of the bonds will fall as their modified duration indicates a significant move from the current duration. In terms of a basic understanding, for those investors new to the concept of duration, from Investopedia: Modified duration is the approximate percentage change in a bond’s price for a 100 basis points change in yield, assuming that the bond’s expected cash flow does not change when the yield changes. As such, there is obviously exposure on the long end in this ETF, if and when rates rise. What this simply means is the bonds in the ETF will not be called if rates rise, the cash flow will stay the same and the value of the debt and underlying ETF will fall in price, accordingly. There is a way to determine weightings on a more in depth analytical level and this would be to examine the ETF on the state level. In terms of state geographic breakdown, the weightings are informative. Here are the top 15 states by weightings: MUB Geography top 15 States State Weight California 23.04% New York 19.17% Texas 9.27% Massachusetts 4.99% New Jersey 4.51% Illinois 3.97% Florida 3.42% Pennsylvania 3.24% Washington 3.24% Georgia 2.50% Maryland 2.38% Arizona 1.67% North Carolina 1.46% District of Columbia 1.24% Connecticut 1.19% Our top three geographic holdings of California, New York and Texas make up 51.48% of the ETF. We expected the high tax states of California and New York to be represented but am a little surprised at the 9.30% weighting of the low,(or zero income) tax state Texas. We expected a higher weighting from Massachusetts and New Jersey. Investors concerned about the fiscal condition of Puerto Rico and its credit exposure will have no issues with this ETF. There are no Puerto Rico issues in this ETF as U.S. territories are excluded from the underlying index. Fees, Performance and Recommendation With an inception date 09/07/2007, the fund has an established track record that has encouraged institutional ownership. Unlike other fund sponsors, we were actually able to obtain detailed information on the underlying index as well. Many readers have appreciated the table format, and we have decided to provide one for this section. The index ticker of the S&P National AMT-Free Municipal Bond Index is {SPMUNUST}. Category {MUB} {SPMUNUST} Net Expense Ratio .25% – Weighted Average Yield to Maturity 1.98% – Weighted Average Maturity 5.49 years 13.53 years 12-Month Yield 2.63% 2.98% SEC 30-Day Yield 1.81% NA Distribution Yield 2.63% 3.07% (YTM) Weighted Average Coupon 4.69% 4.61% Effective Duration/Modified Duration 4.71 years/NA N/A/4.69 years 12-Month Total Return 2.26% 2.98% YTD Total Return .23% .60% Shares Beta/Holdings Beta -0.11/NA NA Annual Portfolio Turnover 5.00% NA Reviewing each of the categories beginning with the Net Expense Ratio of .25%, shows little surprises. The asset class median is .30%. In terms of the yields, they are quite attractive with a reasonably short duration attributed to the call schedule of the issues in the ETF. This is in spite of a weighted average maturity of 13.53 years on the index. The ETF has almost 60% less in terms of the index weighted average due to calls and pre-refunded issues. This attribute lowers the weighted average significantly. In terms of returns the 12 month yield has been consistent and iShares states a tax equivalent distribution yield of 4.65% which is considered quite attractive for high rated municipal bonds. The Year to date return is quite low. This is attributed to the intermittent sell offs in the overall bond market and concerns about rising rates in fixed income markets. There have also been concerns about pension exposure in various states. A few states in the past, such as Kansas in 2014, were charged by the SEC for securities fraud regarding their pension liabilities. While Schwab has warned of possible defaults, downgrades are still possible but mostly in local municipal issues and cities, i.e. Chicago. The exposure to downgrades in the issues in this ETF would be light at best. In any event, with the holdings extremely broad based with state diversification we do not consider this a concern for this particular ETF. The share turnover of 5% is quite low compared with the asset class median of 25%, and the Beta of the shares indicates an extremely low risk investment as compared to equities and almost close to the beta of T-bills (0). The ETF has been and continues to be a stable “cash cow” vehicle for many funds with an increase of 12.83% in the current quarter alone. Some of the largest institutional owners include PNC Financial Services (NYSE: PNC ) (with 7.37% ownership), Bank of America (NYSE: BAC ), UBS Group AG (NYSE: UBS ), and Morgan Stanley (NYSE: MS ). Though, mutual funds have been net sellers for the past few quarters we attribute this to investor concerns over rising rates and further changes to asset allocation models. In any event, overall net flows for the month of June indicate an increase of $108.46M. With a 52-week high of $112.20 and a 52-week low of $107.58, the shares closed at $109.07 -.10 on July 28. Our Recommendation With a very low price range and low beta we do like this ETF as a very low cost way to invest in Municipals in the ETF space during a possible rising rate environment. As many advisors and institutions have decided, this leader of the muni ETFs is an excellent place to invest funds for both the short and long term. As we stated in our analysis on other ETFs, we feel this ETF will continue to provide an attractive yield in a stable-to-slowly rising rate environment. We do expect slight price erosion in a rising rate environment but far less than other municipal funds and ETFs in the marketplace. We do not expect a decrease in yields in this ETF, bearing a large scale default and lower yields going forward. Overall, it is an attractive investment for stable yield-hungry institutions and individual investors alike. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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. Additional disclosure: Information obtained from: ishares.com, morningstar.com, us.spindices.com,fidelity,com, yahoofinance.com, standardandpoors.com, moodys.com, wolfstreet.com,xtf.com, and our own analysis

There Are Few Bargains In Tax-Free Income… Here’s 3

Summary Municipal bonds are coming off one of their best years in a long time. Most municipal bond, closed-end funds are selling well above their usual discount/premium status, a situation nearly exactly opposite that of a few months past. In this article I consider three funds that still present attractive valuations and propose one as my top choice. Few Bargains in Tax-Free Income. Here’s Three. After a dismal 2013, municipal-bond closed-end funds turned in a strong showing in 2014. Let’s start by looking at the largest and most liquid municipal bond ETF as a benchmark. iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) is up 5.42% for the past 12 months and has a 12 month tax-free yield of 2.74%. Not bad for muni bonds, but it doesn’t sound all that terrific, does it? Now, compare that to the median national municipal-bond closed-end fund: 12 month price return of 17.09% coupled with a current, tax-free yield of 5.87%. That’s a total return difference of nearly three fold. How is it that closed-end funds outperformed the benchmark ETF to such an extent? First is their use of leverage: the median muni-bond CEF is leveraged at 34.9%. This can provide a substantial boost in a year such as 2014 but will, of course, drag a fund’s performance down in a less favorable year such as 2013. A second factor is credit quality. Many CEFs will delve more deeply into the credit risk pool than MUB which holds 83% of its portfolio in bonds rated A and above compared to the category average of 74%. Here again, when things go well taking on credit risk can pay off. But in 2013 exaggerated fears of credit risk, driven largely by sentsationalist media coverage of the municipal bond market, proved costly to investors in this asset class. Finally, there’s the factor unique to CEFs: most sell at a discount to their NAVs. This cuts two ways: A discount pumps up the yield on NAV; buying a fund that pays, say, 6% on NAV at a 10% discount turns that 6% into 6.67% at market price. Plus, if a discount compresses, the holder of the fund enjoys capital appreciation unrelated to the price movements of the underlying assets. The first two factors, leverage and portfolio quality, tend to be stable for any given fund. The third, premium/discount status, tends to be quite volatile for municipal bond CEFs, and will often offer attractive buying opportunities. The strong showing for municipal bond CEFs over the last year, and the past few months in particular, has been driven in considerable part by discount compression. This has left few bargains for the tax-free income shopper. The median discount for national municipal-bond CEFs stands at -6.81%. Nearly -7% may look good at first glance but it compares poorly with recent history for the category. How poorly? That -6.81% is more than 2 standard deviations higher (i.e. less discounted) than the median discounts of 3 or 6 months ago. Such numbers do not offer much of an attractive market for buyers. Recent Changes in Premium/Discount Status in Municipal Bond CEFs The metric used to measure how a closed-end fund’s current premium/discount relates to its recent history is the Z-score which indicates how far from the average discount or premium a fund’s current discount or premium is. A fund with a positive Z-score is currently trading at discount or premium higher than its average. Negative Z-scores indicate distance below the average (deeper discounts). Only 4 months ago, when I last wrote about muni-bond CEFs, negative Z-scores were overwhelmingly the rule. That’s now turned around completely with the median Z-scores for 3, 6 and 12 months standing at 2.26, 2.17 and 0.97, respectively. This chart shows distributions of Z-scores for 3 and 6 month periods for 99 national municipal-bond closed-end funds. To see mean reversion in action, it’s worth comparing these to charts of the same metric in Figure 2 from October 2014 which present nearly exact mirror images of these charts in shape if not scale. Figure 1. Z-score distributions for national municipal-bond closed-end funds. In the entire universe of municipal-bond closed-end funds 5% have discounts deeper than their average for the last 3 months and only 8% for the 6 month average. A Moderate Fund-Trading Strategy for Muni-Bond CEFs That Combines Tax-Free Income and Periodic Capital Profits I consider closed-end funds to provide the best choice for exposure to tax-free income. I would argue that the municipal bond arena is the space where CEFs are the clear investment option of choice. They return consistently high-distribution yields on an absolute measure, and very high yields on a tax-adjusted basis in an investment category typified by low yield for essentially every other investment vehicle. Because CEFs often use high leverage and credit-risk as mechanisms to achieve those high returns they tend to be riskier alternatives in comparison with municipal-bond ETFs or holding individual bonds. To moderate some of that risk, I buy muni-bond closed-end funds when they are priced attractively relative to their typical discounts/premiums. To this end I rely on Z-scores to provide a measure of that relationship. I base this on an assumption that the funds with outsized Z-scores will tend to revert to their means over time. Some readers object to this emphasis on Z-scores, which I can appreciate. For the buy-and-hold investor they may be a relatively minor factor in an investment decision. But, I have been able to identify appealing opportunities by including this metric along with the more important considerations of yield and portfolio quality. Understand, as well, that I am always prepared to trade out of a fund if that carefully selected extreme discount reverts to the fund’s less deeply discounted mean, which is, in fact, what I expect to happen most of the time. An investor less inclined to trade funds will, of course, be less inclined to value this metric. Over the past few years I have purchased funds at outsized discounts and sold them at a profit as they reverted to something closer to their mean discounts, using the proceeds to purchase other funds with attractive entry points. With about 100 national muni-bond CEFs and another couple of dozen funds from my home state of California to select from there is always a lot of choice. This approach has provided steady, tax-free income in the 6 to 7% range and modest profits as I traded into new funds. By following this strategy, I presently hold muni-bond funds purchased when they had deeply negative Z-scores. Riding the rising tide in the asset class, they have logged substantial capital appreciation, a fair portion of which is attributable to mean reversion of their discounts. In fact they presently have Z-scores well over 2, so I would like to trade out of them and capture those profits. But there are precious few funds that meet the standards I’m looking for in a replacement. Screen Criteria and Results Can we find some reasonable buys in spite of the clear lack of the sorts of bargains that were available in the recent past? To find out, I downloaded the full list of national muni-bond CEFs from cefanlayzer.com and screened them using the following criteria: Market price yield at or above the median of 5.87%. Discount at or below the median of -6.81%. Z-score for 1, 6 and 12 months being negative for at least 2 of the 3 periods. These are pretty open filters. A few months ago they would have returned dozens of selections to explore. Today the screen passed only two funds: BlackRock Strategic Municipal Trust (NYSE: BSD ) and Dreyfus Strategic Municipal Bond Fund (NYSE: DSM ). With so few candidates, I opened the filter a bit more, stretching the market-price yield down to 5.80%, a bit below the median yield of 5.87%. This added a third candidate, Eaton Vance Municipal Bond Fund II (NYSEMKT: EIV ). This table summarizes yield on market-price, discount and Z-score values for the three funds. Figure 2. Yield, Discount and Z-Scores (Source: cefanlayzer.com ). When I write about tax-free municipal bond funds I like to show the equivalent tax-free yields for investors at a range of marginal tax rates, which I feel gives a better sense of how appropriate a yield point may be in for any individual’s case. Here’s the table. Figure 3. Taxable equivalents for Federal Marginal Tax Rates. As you can see, for an investor in the mid to upper tax brackets, the CEFs are providing extremely attractive tax-adjusted yields compared to what’s available in today’s fixed-income environment. Even at the lowest tax brackets one would be hard pressed to find fixed-income investments with comparable yield and safety. The Funds This next table summarizes some key features of each of the three closed-end funds under consideration. Figure 4. Leverage, Maturity, Duration, Credit Quality and Morningstar Ratings (Sources: cefanalyzer.com and Morningstar). BlackRock Strategic Municipal Trust has been selling at a discount between -4 and -8% since mid-2013. It’s current discount reflects a move upward from a low of -9.84% in August 2014. Distributions are paid monthly and have been steady at $0.074/share since 2010. The fund has not paid out return of capital since its inception. The top 5 states represented are Texas (13.3%), Illinois (11.2%), New York (9.2%), California (8.7%), New Jersey (6.1%). Tobacco bonds, generally considered the riskiest of muni bond categories, are not included in the top 5 sectors held in the portfolio. Morningstar rates the fund as having high to above average risk. The fund has a Sharpe ratio of 1.63 relative to the benchmark Barclays Index of 1.14. Dreyfus Strategic Municipal Bond Fund has been selling at a discount near -5% since early in 2013. Its present discount of -6.8% is marginally lower than its recent history and a full standard deviation below its one year average discount. Distributions are paid monthly. They were cut from $0.0475 to $0.0415/share in November 2014. The fund does not pay any return of capital in its distributions. Top five states are Texas (15.2%), California (12.6%), New York (11.8%), Massachusetts (8.1%), and Arizona ((4.5%). Morningstar rates the fund as having average risk. The fund’s Sharpe ratio is 1.09 relative to the benchmark’s 1.14. Some might express concern about the lead role of Texas in these two portfolios in light of the possible negative impacts of the oil crash on local municipal revenues. It’s just about impossible to sort out how much or little of a factor this may be. My inclination is to dismiss this as an immediate worry. Municipal bond default rates are so low relative to essentially all other bond categories, that I consider this risk exceptionally low on the list of possible risks for the funds. Eaton Vance Municipal Bond Fund II is the final of the three funds. It has seen its discount move to -8.1% at present which is above the -9% range it fell to during November and December 2014. Otherwise it’s about as low as it has been since late 2013. This is just short of one standard deviation below its 12 month average discount. The fund’s monthly $0.0631/share distribution has held steady since a drop in 2012. The fund does not pay return of capital in its distributions. The top holdings in the portfolio comprise bonds from New York (10.3%), Florida (7.5%), Pennsylvania (7.5%), New Jersey (7.1%) and Massachusetts (5.8%). Morningstar rates the fund as having above average risk metrics. Its Sharpe ratio is 1.21 compared to the benchmark’s 1.14. Most notable about EIV is that it has excellent credit quality. Recall that the category average for bonds rated A and above is 74% and for MUB, the benchmark ETF, it’s 83%. Compare EIV: With 92% of its bond portfolio rated A or better, credit risk becomes a near insignificant factor. Finally, EIV outperformed its category in 2014 on a NAV and market price basis despite having not suffered the significant discount compression along the way that its peer funds did. Summary and My Top Choice Any of the three I’ve listed here are, in my view, worthy of a hard, close look for those exploring an investment in tax-free high-yield. My top choice would be the Eaton Vance offering, EIV, but my enthusiasm for it as top choice is somewhat tempered. On the plus side is its portfolio characteristics (credit quality, maturity and duration) which are clearly the best of the three. At

Vanguard Set To Move Into Muni Bond ETF Space

Vanguard Group, known for its low cost offerings, plans to make inroads to the increasingly popular muni bond ETFs space. Vanguard’s entry appears well timed, as the muni bond ETFs space has been on a roll since last year. In fact, the overall muni category managed to secure the third best position in 2014 having added 8.7%, its three-year highest. It’s not that the issuer is entirely new to munis. Presently, there are 12 actively managed Vanguard muni-bond funds worth $140 billion. The issuer expects the fund to be up for sale by the end of June. The fund will trade under the name of Vanguard Tax-Exempt Bond Index Fund . The Proposed Fund in Focus As per the SEC filing , the fund looks to track the performance of the investment-grade U.S. municipal bond market. The goal will be achieved by tracking the S&P’s National AMT-Free Municipal Bond Index. The index includes bonds having a minimum term to maturity greater than or equal to one calendar month. The “investor” share class will have to spend 0.2% in annual fees to own the fund. How Does it Fit in a Portfolio? Municipal bonds are great picks for investors seeking a steady stream of tax free income. Usually the interest income from munis is exempt from federal tax and sometimes even state taxes, making it especially attractive to investors in the high tax bracket looking to reduce their tax liability. The proposed fund too looks to follow munis that have their interests excused by U.S. federal income taxes and the federal alternative minimum tax (AMT). However, investors should note that tax-free bonds yield lower than taxable bonds. With the increase in the U.S. taxes, demand for municipal bonds has grown by leaps and bounds among high earners. Can it Succeed? There are quite a number of choices in the municipal bond space with iShares National AMT Free-Muni Bond Fund (NYSEARCA: MUB ) being the highest grossing ETF with about $4.2 billion. MUB tracks the S&P National AMT-Free Municipal Bond Index to provide exposure to a basket of 2,458 investment grade securities. The average maturity for the fund stands at 5.51 years, while duration is 6.33 years. The fund has a 30-day SEC yield of 1.58% and charges 25 basis points as expenses per year. Interestingly, the newly filed fund also follows the same index that MUB tracks. So it goes without saying that the proposed fund will face tough competition from the largest ETF in the space, i.e. iShares’ MUB. While the lack of first-movers advantage will be a negative for Vanguard, its ability to roll out a product on an ultra low price should give it an edge over many others presently on offer. Going by fundamentals, intermediate term munis offer great opportunities right now especially with the improving fiscal health of the U.S. states and a plunge in intermediate-to-long term yields. The only bump in the road ahead for Vanguard is its late entry to this space. It’s hard to predict how Vanguard’s new product would perform, but a low expense ratio should be the key to a sizable asset base or greater market share than iShares’ ultra-popular product.