Why I Still Like Munis But Recently Made Some Portfolio Adjustments

Summary

• After growing cautious on municipal bonds at the beginning of the year, there are reasons to be more optimistic going forward.
• The recent stimulus bill limits the credit risk, especially for investment grade munis, with a lot of support going to state and local governments.
• Monthly flows into muni funds remain positive, illustrating this is still a sector that is in favor.
• While credit risk is muted, interest rate risk is a major concern. With many muni funds having high duration levels, I made a swap into the lower duration alternative.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

Main Thesis/Background

The purpose of this article is to discuss the broader municipal bond market, with a specific focus on some adjustments I made to my portfolio. This is a follow-up to my review a few months ago, when I highlighted some of the major risks facing the sector. As a long-time holder of muni bonds, I have promoted this investment theme for a long time, but saw some heightened risks as 2021 got underway. These included slower than expected state/local economic recoveries, credit risk if stimulus aid fell short, and a heightened level of interest rate risk as treasury yields started rising.

Fast forward to today, and we seem to be in a better place. This makes me confident that this sector continues to have a place in my portfolio, and I will likely add at a moderated pace in the months ahead. The key reasons behind this outlook is that the economic recovery in the U.S. is progressing fairly well, and a recent stimulus bill out of Washington provides a high level of support to state and local governments. This eases short-term credit risk, in my view.

However, with treasury yields continuing to rise, interest rate risk remains high. Investors should focus on this attribute because many muni ETFs and CEFs have fairly high durations. While not necessarily unique to munis, as corporate bonds face a similar risk profile, this reality will limit the returns to muni bonds all the same. With this in mind, I made some portfolio adjustments that I wanted to discuss, which I believe allows me to capitalize on the positives of munis, while also limiting some of that duration risk.

Primary Change - Swapping MUS/MHD for NIQ

As I alluded to above, my primary focus right now is limiting interest rate risk. The rationale is two-fold. One, yields are starting to rise, which pressures the value of bonds. In fact, the rise has been mostly uninterrupted since 2021 got underway, which is why many fixed-income sectors are seeing year-to-date weakness, as illustrated below:

Source: Vanguard

Clearly, this is a challenge for fixed-income as a whole, but also in particular for investment grade assets. With respect to munis, this is certainly relevant, as muni bond funds have seen their duration levels rise over time. With quality issuers locking in lower rates for longer, the interest rate sensitivity of this sector grew. In fact, my three primary muni CEF investments in early 2021, the Nuveen AMT-Free Quality Municipal Income Fund (NEA), the BlackRock MuniHoldings Quality Fund (MUS), and the BlackRock Taxable Muni Bond Trust (BBN), all had high duration levels. NEA and BBN's current durations are shown below, respectively:

Source: Nuveen

*I did not include MUS because the ticker has been retired and, therefore, does not have a current duration. But it had a duration in line with the two funds mentioned above earlier this year before being consolidated.

It should make sense, given these high durations, why I wanted to limit my duration exposure throughout 2021. But, how did I do that? The primary way I went about it was swapping a higher duration fund for one that had a more managed duration approach, and therefore less interest rate sensitivity. The perfect time came up a few months ago, when MUS was set to be absorbed by the MuniHoldings Fund (MHD). Going into this consolidation, MUS began to rise in value, and I saw the perfect opportunity to take some profit and shift my assets around.

I did this for two reasons. One, MHD has a high duration level, just like MUS did, as shown below:

Source: BlackRock

Therefore, allowing the MUS/MHD consolidation to proceed in my portfolio did not meet my objective. Further, there were some credit concerns I had with MHD, to the point where I just did not feel comfortable owning it. In particular, the fund has almost 4% exposure to Puerto Rico, which is a jurisdiction I do not want to own:

Source: BlackRock

This is a jurisdiction that has had a host of credit issues in the past and, even though it was a relatively small rating, I do not want to see Puerto Rico in the top listing of any fund I own.

So, my next step, after deciding I did not want to own MHD, was to determine which fund I wanted to shift assets into. Ultimately, I landed on the Nuveen Intermediate Duration Quality Municipal Term Fund (NIQ) for a few reasons. One, at the time of purchase, the fund had a discount to NAV over 3% (this has since narrowed to around 1.5%, a valuation I still find attractive). Two, the fund has a managed duration objective, with a focus on more intermediate-term bonds. The end result is less interest rate sensitivity, which is precisely what I am looking for right now:

Source: Nuveen

Of course, NIQ still will be impacted by rising yields. A duration of 7.5 years is not "low", so I want to manage expectations here. If yields and rates move markedly higher, NIQ could suffer. However, I see yields hitting a bit of a cap soon, especially if they move closer to 2%. Further, while this duration is not low, it compares very favorably to my other holdings. It is almost half the level of BBN, and is about 30% lower than NEA. Similarly, it has much less interest rate sensitivity than MHD, which is what I would have owned had I not made a swap.

My ultimate point here is that I wanted to limit my exposure to one of the biggest risks facing the market, which is rising yields. Moving into NIQ, at the expense of other popular options, does precisely that. In addition, to compound this effect, I have decided to tax the distributions from both BBN and NEA, which have higher durations, and use those proceeds to accumulate more shares in NIQ. This means, over the course of 2021, my interest rate sensitivity, with respect to my muni holders, will decline. I view this as a common-sense way to limit my duration risk, while also not liquidating my current holdings and triggering more taxable gains than necessary.

Munis Remain Popular With Investors

My next few points will look at why I continue to favor munis, despite some of the concerns I had just a few months ago. One reason has to do with investment sentiment, which shows munis have remained in favor, despite a pandemic and an unclear outlook for federal support. While we know now that the latest stimulus package provided aid to state and local governments, that was not guaranteed back in January and February. Yet, investors continued to pile into the sector. In fact, net flows to muni funds have been positive every month since May of 2020, as illustrated below:

Source: Lord Abbett

My takeaway here is pretty simple. Munis remain a popular asset class, and this demand should continue to help generate positive returns in the sector. Despite heavy investor selling during the worst of the pandemic, we are back to a sense of normalcy, and I remain confident having some exposure to this sector is the right move for me.

State and Local Aid Came Through

Expanding on the prior paragraph, there is plenty of support to suggest munis will remain in favor in the months ahead. As I noted, muni demand remained strong, despite an uncertain backdrop. Then, with the passage of the American Rescue Plan, we got some of that certainty we were craving.

Specifically, the legislation has offered state governments, local governments, and other muni bond issuers a tremendous amount of support. According to data compiled by Lord Abbett, top beneficiaries, besides state and local governments, are hospitals and other healthcare providers, school districts, and airports, as shown below:

Source: Lord Abbett

This is significant, because it will support both the general obligation and revenue bond markets. Both of these arenas are key to the total return potential for the municipal market as a whole, so seeing support for both asset types was welcomed.

The point here is credit risk has been scaled back significantly. While many municipalities remain under pressure from partial lock-downs and stubborn unemployment, this fiscal aid should help them get back on track while they wait for the eventual full recovery. Seeing the credit profile improve by a measurable amount removes a key headwind I saw for 2021.

Tax Increases A Tailwind, SALT Deduction Is The Wildcard

My final next point also has a macro focus, but looks at a push-pull dynamic that clouds the outlook going forward. As I mentioned above, I see a few positive catalysts for munis in the short term. However, as we look past that and into the potential longer term move, I see the potential for tax legislation having a major impact on the muni market later this year and in 2022. The problem is, it is not clear whether this impact will be positive or negative.

To understand why, let us look at some of the principal tax changes that may come out of Washington under a President Biden and a Democratic-controlled Congress. The first item is likely to have a positive impact for munis as a whole. This is higher taxes, on both high-income individuals and corporations, two groups that make up a large percentage of muni bond buyers. As their tax rates go up, we can reasonably expect their demand for munis will as well.

Importantly, this seems like a very real possibility. President Biden recently reiterated his support for higher taxes, stating in an interview with ABC News last month that those who make over $400,000 annually will:

"see a small to significant tax increase"

Source: ABC News

In that interview, he also expressed support for raising the corporate tax rate, which he views should be near the 28% level (up from 21% now).

If implemented, this could drive demand and therefore increase the underlying value of muni bonds. This would be a win for holders of munis in pretty much all muni funds.

With this backdrop, what is the problem? Well, there are a few details that could steer this rising demand story off course. One, tax legislation is a long way off. Congress has not yet taken up the issue, and other pandemic relief or economic relief measures are likely to come first, if they are needed.

If we see problems on either end, an uptick in new Covid-19 cases or a fledgling economy, tax reform will probably be pushed back. Further, even if it is taken up this year, changes to the tax code probably won't take effect until 2022 (at the earliest). This will limit the immediate demand for munis, and the corresponding gains that could accompany this demand.

Aside from those developments, I have another concern when it comes to tax changes. Specifically, this concerns the SALT deduction cap, which went into effect in the 2017 tax reform bill. What this did was cap the deduction for state and local taxes at $10,000, hitting high-income residents of high-tax states particularly hard. These individuals were accustomed to have large federal deductions because of their state and local tax obligations. With a cap at $10,000, their federal tax bills rose significantly, which created a major demand catalyst for tax-exempt debt. This legislation created a multi-year positive demand trend for muni bonds, which is now at risk.

The reason is, many Democrats are in charge of high-tax states, so their residents and constituents were disproportionately impacted by this change. With Democrats now in control of the White House, House, and having the tie-breaking vote in the Senate, a change to the SALT deduction cap is a real possibility. In fact, just this past week, Congressman Thomas Suozzi, who represents New York's 3rd District, stated won't back any Biden-proposed tax increases unless there is a repeal of the $10,000 SALT deduction cap. He was quoted last Monday saying simply:

No SALT, no deal"

Source: Bloomberg

My takeaway here is there are a lot of moving pieces in this tax equation, which makes the impact on muni demand unclear. For one, the Democrats have a very slim majority, so any legislation that includes tax hikes is likely to be hard-fought. Two, many Democrats will want to include a repeal/revision of the SALT deduction cap in any upcoming tax bill. The impact of an elimination of the SALT deduction cap could negate the benefit from higher taxes, in terms of demand for municipal bonds. This is because, for high-income earners, a higher absolute federal tax rate, coupled with the allowance for more deductions, could have a neutral, or even negative, impact on their final tax bill. If that is the case, then the need for tax-exempt debt is no longer as great.

My conclusion is, therefore, that the future demand story is actually a bit cloudy. This is a point worth emphasizing because while I see merit to holding munis, readers should understand this sector has plenty of political, as well as interest rate, risk.

Bottom line

Munis will remain in my portfolio in 2021, but I have taken a more active approach to a sector that I used to view passively. I have moved into lower duration funds, and will continue to boost that exposure at the expense of my higher duration CEFs. Looking ahead, I like the demand story for munis, but it remains mixed due to the uncertain tax environment for future years. As a result, I believe investors looking for tax-exempt income will do well with muni bonds, but they need to carefully assess some of the unique risks to this sector before diving in at this time.

Analyst’s Disclosure: I am/we are long NEA, NIQ, 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.