What's Going on with iShares Muni Bond ETF?

Arbitrage is not working now for MUB.

The Vanguard National Muni Bond Fund [VWLUX] and the iShares National Muni Bond ETF (MUB) have similar attributes:

• Duration: MUB 7.45 years, VWLUX 7.0 years
• SEC yield: 4.65%, 4.80%
• Number of holdings: 207, 348

They don’t have similar assets. VWLUX has $2.9 billion and MUB has $0.8 billion.

Importantly, VWLUX does not rely on an arbitrage function to close the gap between the market price and NAV. As a no-load mutual fund, the price and the NAV are equal. The arbitrage function for MUB has not been working though.

The retail market is buying, but the institutions that are supposed to arb away premiums and discounts are not stepping in. As of now the premium on MUB is over 2.4% — that’s big.

The following chart shows the performance of MUB relative to VWLUX.

If the arbitrage was working, MUB would probably not have such a contrasting performance relative to VWLUX. We suppose that means when the arbs resume full functionality, MUB will decline.

Comments

[Indexor:]

Richard:
Thanks for pointing out the Arb problem. Sadly, MUB broke down Oct 7, precisely at 2:00 PM (EST), with a relatively small trade that immediately shaved 3% of its value, placing it at a sharp discount and the begining of a rapid price decline. A call to iShares that day provided no insight other than a comment that it was believed short sellers had recently increased positions in the fund. Liquidity evaporated for municipals that day, as it had for most non-Treasury fixed-income ETFs. As the price continued its rapid descent, it was extremely difficult to liquidate MUB shares that week, even at full Bid prices.

The credit crisis seems to have taken arbitrageurs out of the game, relegating MUB and most other non-Treasury fixed-income ETFs to the same status as Closed-End-Funds. This has been a very troubling development and brings up a question as to whether the ETF structure is viable for fixed-income investments.

As you stated: "If the arbitrage was working, MUB would probably not have such a contrasting performance relative to VWLUX. We suppose that means when the arbs resume full functionality, MUB will decline." My question - Will arbitrage ever return?

2008 Dec 07 12:40 PM