MUB: Aligns With The House View, But We’d Rather Go Zero Credit Risk

The iShares National Muni Bond ETF (NYSEARCA:MUB) tracks the listed muni bond market, with substantial exposure to California and New York states in the US. The duration is quite long on this ETF at 6 years, so speculation on relatively short-term factors will matter. The ETF is super efficient with an expense ratio of 0.05%.

We have refined our view on macro from being that rates will stay higher than expected, to rates will stay higher than expected unless maturity walls make a major issue for the economy, and that real yields will fall especially dramatically as inflation will be quite sticky despite pressures all around. The MUB lines up with that, although we’d rather take out California and New York from the equation, where we have concerns, expanded on from a brief mention in our last coverage, about the laxness of credit ratings of those states given what we believe might be persistent trends, such as poor governance, high taxes and housing issues driving businesses away to places like Texas.

Explaining Our Logic

Essentially, we are concerned with the maturity walls in 2024 and 2025, when a very outsized proportion of debt (25% of corporate debt in the US is maturing in 2024) will come due and need to be refinanced at higher rates. Both households and corporates have had quite a lot of fixed debt on their balance sheets, which means that the Fed transmission mechanism might have been dampened explaining the resilience of the economy so far, as well as the resistance of inflation to tick down.

We believe that in spite of economic conditions, inflation will remain stickier than expected due to the fact that quite a lot of wage increases, where wage inflation remains way too high, have been negotiated on long-term contracts such as in unions. Otherwise, inflation expectations for the next year and two years remain above policy targets, which will bake into all sorts of contractual agreements like PPAs in utilities, or any other service that is contracted for future periods. In general, inflation expectations even when not concretely baked into commercial arrangements have an impact on anchoring inflation, where it’s currently anchored at higher levels.

On the other hand, the Fed is signaling rate cuts, likely fully aware of all of this because they also have to consider the growth part of their mandate. Powell continues to reference the various ways in which higher rates cannot continue due to risks to the growth agenda, such as commercial real estate credit risks, and the link between employment and residential real estate credit conditions if unemployment were to rise alarmingly. Unemployment is already rising slightly.

With the maturity walls causing the current restrictions in money availability to hit home to corporate bottom lines, we think that this is where the recessionary pressure from the Fed policies will appear. In other words, the recessionary effects of the maturity wall should materialise this year and cause the rate declines, even before the inflation battle is over, and perhaps without even completing the inflation battle, although we believe inflation will just about come down sufficiently with a recessionary wave.

Commentators have been discussing jobs data for not all of the right reasons. They have been discussing jobs data because of the link between employment and inflation ala Phillips Curve logic, where wage growth sets a persistent element of the inflation picture. We are looking at jobs data also to see how it trends in the face of the maturity wall, where 25% of corporate debt will have to be refinanced by the end of the year.

The duration of around 6 years measures partially the sensitivity of a bond to changes in rates, but that assumes the rate change applies across the yield curve. This is rarely the case, where forward rates may change in opposite directions to forecast changes in current rates, or at any rate may not change in relation to shorter-term rate changes. Nonetheless, it is a coarse measure of sensitivity and also tells us where on the yield curve changes in rates will matter for the bonds contained within the ETF. The concerns around the maturity wall definitely apply over a period of 6 years, so it lines up fairly well with the impact horizon from the events we’re discussing.

Bottom Line

However, would we use MUB? Probably not, as there is another element to consider with MUB that confounds the picture, which is the credit rating.

The credit situation in California and New York is important. While Illinois is the most leveraged, both New York and, to a lesser extent, California have high leverage ratios. This is the case while also having exorbitant taxes and insufficient public services. Meanwhile, Texas has low leverage with low taxes and fewer social disasters. Corporations have seen this and there is a meaningful move of some companies to Texas. Many of the largest California-based companies are in tech, and many don’t have much of a manufacturing footprint in the region and could easily move their businesses elsewhere. We believe that if a tech cluster of sufficient efficiency forms in Texas to support human capitally intense tech businesses, California is going to have an acceleration of this exodus. Some of the same points apply to New York as well.

While this may be a tired and relatively well-absorbed narrative in the public, the credit rating agencies are taking a very rearview approach, referring mainly to current state income as an important driver of ratings. Also, California is quite levered to capital gains and is therefore a cyclical state in terms of budget health. A recession hurts for California, or a bubble bursting in AI. No reference at all is made to companies eyeing moves of their businesses to other places. We think the main thing stopping tech companies from doing so is there needs to be a sufficiently strong tech cluster to support human resource needs in Texas for that to happen, which is probably underway in Austin. The lack of reference to these outstanding risks, even if remote, concerns us on the part of the rating agencies, and we’d reserve the possibility of worsening credit ratings long-term for a lot of these states. The likelihood of higher terminal rates on account of what we believe will be quite resistant to inflation doesn’t help either.

Because there’s this confounding negative on the credit rating side of things, particularly for California in our opinion, we’d prefer other ways to play out our macroeconomic speculations.