NBB: A Good Option For Taxable Muni Exposure, But Upside Limited

Summary

• NBB sits just under its 52-week high and sports a premium to NAV of almost 3%.
• While this fund has been a reasonable performer over the past few months, I believe getting a bit more cautious now makes sense.
• Taxable muni CEFs offer a way to boost yield without going down in credit quality. Therefore, I see them as a valid hedge but would be leery of over-paying for that exposure.
• The recent stimulus measure did not include much direct aid to state and local governments. If this story continues in 2021, muni bonds of all stripes face significant risks.
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Main Thesis

The purpose of this article is to evaluate the Nuveen Taxable Municipal Income Fund (NYSE:NBB) as an investment option at its current market price. I will continue to use muni bonds as an equity hedge in the new year and see taxable munis as a reasonable way to increase my portfolio's risk without taking on too much credit risk. NBB is made up of investment-grade bonds, and its recent UNII report illustrates the fund is over earning its current distribution rate. When we couple this with NBB's relative value against other taxable muni CEFs, it seems like a reasonable play right now.

Despite these positives, there are also reasons to be cautious. NBB does offer a relative value for the sector, but in isolation its price is not cheap. The fund has a 3% premium to NAV, well above its average for the year. Further, NBB is disproportionately exposed to bonds from California and New York, two of the epicenters of the Covid-19 crisis. With state finances to be an issue in 2021, especially without aid from D.C., investors should recognize the risks in this sector are quite different now than they are under normal conditions.

Background

First, a little background on NBB. The fund is run by Nuveen and its primary objective is "current income through investments in taxable municipal securities." Currently, NBB trades at $23.52/share and yields 4.75% annually, paying monthly distributions. I initiated coverage on NBB back in August, and put a bullish rating on the fund, as I am generally optimistic on the taxable muni space. In hindsight, this was a reasonable outlook, as NBB has seen a decent gain since that time, as shown below:

Source: Seeking Alpha

As we approach 2021, I thought it was an opportune time to take another look at this fund. While I continue to believe municipal bonds, whether tax-exempt or taxable, could play a vital role in the new year, I am also a little concerned with the valuations across the taxable space. Ultimately, there are some pros and cons that help balance each other out, making a neutral view the most appropriate for NBB going forward, and I will explain why in detail below.

Tax-Exempt Yields Have Hit Pre-Crisis Levels, Taxables Could Be An Alternative

To begin, I want to take a look at a few reasons why someone would want to consider the taxable muni space, as opposed to tax-exempt munis, right now. Clearly, avoiding income taxes on distributions is preferable (all other things being equal), so whenever an investor is looking at the muni world as a whole, they should at least be considering tax-exempt munis in their analysis. Of course, there are plenty of valid reasons why an investor would choose a taxable security or fund. Perhaps they are planning on buying it in a tax-deferred retirement account, making current taxes a moot point. Another reason could be the investor is domiciled overseas or is in a low federal tax bracket or in a low-tax state. These considerations could make taxable securities less detrimental than to an investor facing above-average tax rates.

Aside from those points, another reason one may elect to buy taxable muni bonds at the expense of tax-exempt muni bonds is the relative income stream. What I mean is, even once taxes are considered, perhaps the after-tax yield on the taxable security is still higher than the tax-exempt. This is a very relevant consideration right now, as tax-exempt yields have dropped significantly since the pandemic started. In fact, tax-exempt yields have fallen below their pre-crisis lows in the investment-grade category, as shown below:

Source: Bloomberg

I have two primary takeaways from this graphic. One, tax-exempt munis are not offering much in terms of income right now. Yes, the underlying bonds could still rise in value and, yes, the income stream is tax-free. These are very positive attributes, so I remain attracted to that asset class as a whole. But the bottom-line is the income stream is small, in isolation and when compared to the past few years. Therefore, if an investor is looking for a higher income stream, they have a few options. Buy a leveraged fund, which will compound the yield from buying securities that offer more income than the interest expense for borrowing. Or they could go down the credit ladder and receive a higher yield for taking on credit risk. As you can see, high yield munis are offering almost four times the income, and their yields remain above pre-crisis levels. This signals investors are indeed receiving additional compensation for that risk and could very well be justified in shifting to that sector.

While the two options above are valid, there is a third option, which is the point of this review - taxable munis. For the more risk averse investor, such as myself, buying high yield securities may not be very appealing. By lowering credit quality, one is more exposed to default risk, which is certainly elevated due to the pandemic. In lieu of this option, one could move into taxable munis to boost their income stream. While they will not receive the tax benefits that tax-exempt high yield munis offer, they would not be sacrificing credit quality. For example, NBB, along with most taxable muni fund offerings, has mostly investment-grade bonds. In fact, not only are over 90% of the underlying holdings rated investment-grade but the vast majority are also rated A or better:

Source: Nuveen

My point here is to illustrate that taxable munis, or funds like NBB, offer investors a way to boost their yield without sacrificing credit quality. As yields on tax-exempt munis have tightened significantly, this will be a very relevant consideration going into 2021. As a result, I believe the two sectors could complement each other nicely going forward and keep credit quality in check.

Why Choose NBB - Relative Value To Alternatives

While the above discussion centered on taxable munis as a whole, I will now shift to NBB specifically. As I noted, using leverage or going down credit quality are two ways for muni investors to increase their yield. NBB stays within the investment-grade realm, but it is a leveraged fund, so its yield is noticeably higher than a non-leveraged taxable fund. I bring this up because it is important to understand NBB is not offering a yield near 5% simply by offering taxable munis. That is one characteristic, leverage is the other. For comparison, consider that a popular taxable muni ETF (non-leveraged), Invesco Build America Bond Portfolio ETF (BAB), has a current yield of 2.96%. This is a fund that may be of more use to investors who want to focus on investment-grade bonds and avoid using leverage, and is one I wrote positively about last month here.

While BAB is a valid option, using leverage could be the right move for an investor who does not anticipate another sharp sell-off, and who believes investment-grade munis will see limited defaults. I concur with both those points, which is why I feel comfortable using leverage in my muni holdings. With that in mind, one aspect that makes NBB stand out is its relative value compared to the other primary CEF players in the space. For comparison, let us look at a few key metrics for NBB, along with the BlackRock Taxable Municipal Bond Trust (BBN) and the Guggenheim Build America Bonds Managed Duration Trust (GBAB), in the chart below:

Fund	Leverage %	Premium	Yield
NBB	37%	2.91%	4.75%
BBN	32%	7.32%	5.18%
GBAB*	22%	7.57%	6.04%

Click to enlarge

Source: BlackRock; Nuveen; Guggenheim

(*GBAB employs less leverage but has a higher yield due to its inclusion of high yield bonds and other assets in addition to taxable munis)

Clearly, NBB is much cheaper than those alternatives, in terms of premiums. While investors would be sacrificing some yield, the cost of ownership is worth noting. Importantly, all of these funds have seen their premiums increase markedly over the course of 2020, which makes new positions now seem expensive. Therefore, for investors concerned about buying in late cycle, NBB's premium advantage could make it the better option at the moment.

Despite Relative Value, NBB Expensive In Isolation

So far, in this review, I have taken a positive view of NBB and suggested why it merits some consideration. However, I stated at the beginning that I have a neutral view on the fund and expected limited upside in the short term. Therefore, I must balance out the positive points above, with a few reasons why it also makes sense to be cautious and not go "all in" at these levels.

Specifically, while there is truth to NBB's relative value discussed above, we also have to consider its value in isolation. Yes, NBB is cheaper than BBN and GBAB, but that does not mean it is cheap. As investors are likely aware, finding true value in today's market is a challenge, and I do not want readers coming away with the idea that NBB is a bargain. While its valuation exposes the expensive prices of BBN and GBAB, we should note that NBB is sitting just under its 52-week high, after an impressive run in 2020, as shown below:

Source: Seeking Alpha

Certainly, NBB is at the top end of its range. Of course, that does not mean the fund cannot move higher, but it should present a reason for at least some caution. Further, it is not just the absolute price that looks expensive for NBB. The fund's premium to NAV is also near its top, which is a measure to monitor very carefully for leveraged CEFs. While the 3% premium may not seem as too aggressive, readers should note that NBB's premium high over the past year was 4.45%. This puts the current level within striking distance of that high. Furthermore, the average valuation of NBB is actually a slight discount to NAV, again supporting the notion that the fund is a bit pricey in its own right. For a quick snapshot of NBB's valuation story, see the chart below:

Source: Nuveen

I view these charts as a clear reason why the upside potential for NBB is limited. The fund's history suggests its premium will not rise much further and, given the run muni bonds have had already since the Q1 sell-off, there is a limit to how much underlying appreciation of those bonds NBB will benefit from. Simply, while I do not see a big drop in the cards for NBB, the chances of substantial gains in the next few months seem slim.

Income Story Is Mixed

My next point takes a look at the income story for the fund. As I noted above, NBB has a yield of 4.75%, which is quite attractive in this environment, even if it is taxable. However, investors need to consider how sustainable this yield is when evaluating the fund, especially given all the refinancing activity that has taken place in both in the corporate and municipal sectors.

Fortunately, NBB has been consistent in its distribution rate in 2020, and I don't see a major risk to this income stream in the new year. The fund is earning income slightly above its stated distribution rate, which suggests the current rate is sustainable, as shown below:

Source: Nuveen

Certainly, that is good news, but readers should also consider the negative UNII balance for the fund right now. At almost $.06/share, NBB has roughly two-thirds of a month's worth of distributions in arrears. While its current income level should help to chip away at this negative metric over time, it does suggest little room for error going forward. If the income stumbles, due to some defaults or refinancings, then this negative balance will become a real concern. Therefore, I do not see any reason to be alarmed now but will continue to monitor these metrics carefully over the next few months.

Understand The Concentration Risk

The final element I will look at for this review is the fund's underlying exposure. This is another important consideration because while NBB is a national fund, it is heavily exposed to a few individual states. In fact, California and New York combine to make up over 41% of total assets, as shown below:

Source: Nuveen

As you can see, NBB is quite reliant on the bonds originating from those two states. This is not inherently "bad", but it does expose investors to concentration risk, so it is something to be keenly aware of. Both of these states are historically big players in the tax-exempt and taxable muni space, and their inclusion is generally a positive. However, the economic impact from the pandemic presents new risks for state and local government budgets, so spreading out the risk between more states may make sense here.

In this vein, investors should note both California and New York have been epicenters of the current crisis, and their budget woes, as a result, are well known. While defaults have been limited so far, many states, including these two, have been requesting aid from Congress. To date, little has been done on this front. Looking ahead of 2021, there is a stronger possibility that state and local governments will receive aid if a President Biden makes it a priority when President Trump has not. Further, the outcome of the Georgia Senate races could have major implications for this sector. If the Democrats win control of all three branches of government, I would expect large levels of aid to flow to the states. If the Republicans prevail, I still expect some aid to be forthcoming, but it will be more smaller and more targeted in scope, in my opinion.

For support, consider the recently signed $900 billion stimulus bill from Congress provided little direct aid to state and local governments, as reported by Reuters. This was the result of a compromise struck by a divided government and could foreshadow what we will see in 2021 if the government remains divided. While there are plenty of valid arguments for being against direct federal aid to state and local governments, from the standpoint of investing in NBB, this is a major headwind. When we consider NBB is heavily invested in bonds originating from California and New York, two states that are very much in need of fiscal help, the implication should be clear. Therefore, for investors who are anticipating a Republican win in Georgia, or simply believe federal aid will fall short in 2021 for other reasons, they would be wise to approach positions in NBB very carefully.

Bottom line

I continue to see value in taxable munis, but believe new positions should be made with care. The primary CEFs in the space are all sitting at historically high levels, and federal aid that would benefit the underlying bonds directly has been lacking. As we enter 2021, the income stream offered by NBB, and other taxable muni funds, does have a large edge over tax-exempt munis. However, there are serious headwinds, such as continued economic shutdowns and budgetary pressures, that make the sector riskier than normal. Therefore, I believe a neutral view on NBB is well supported at this time.

Disclosure: I am/we are long BBN. 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.