BAB: A Year Later, I'd Still Tread Carefully On Taxable Munis/Build America Bonds

seekingalpha06-10

Invesco Taxable Municipal Bond ETF is a passive ETF that tracks the performance of US dollar-denominated taxable municipal debt.The outlook for BAB is modest, with a potential for 2-3% returns, which ...

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Still, that doesn't mean there aren't any bullish catalysts for BAB. One is that the underlying securities are getting a boost from low levels of issuance in 2024. With interest rates elevated, many muni issuers are pumping the brakes on raising new funds - as that would require paying elevated borrowing costs to do so. Many municipalities and public works projects are resorting to tax increases and/or tolls and usage fees to cover costs, rather than issuing taxable munis for fundraising. The net result has been a steady decline in supply for this sector, as shown clearly in the graphic below: New Issuance - Taxable Munis   The premise here is that as long as supply remains tight, underlying valuations are supported. That doesn't mean t","collect":0,"end_time":0,"defaultTopTitle":"seekingalpha.com","property":[],"viewcount":null,"language":"en","relate_stocks":{"FDN":"First Trust Dow Jones Internet I","BK4585":"ETF&股票定投概念","BGSX":"Build Acquisition Corp","BK4588":"碎股","BK4550":"红杉资本持仓","BAB":"Invesco Taxable Municipal Bond ETF"},"translate_title":"BAB：一年后，我仍然会谨慎对待应税市政债券/建设美国债券","themeId":null,"isJumpTheme":false,"ttsUrl":null,"symbols_score_info":{"BGSX":1,"BAB":1,"US3Y.BOND":0.9,"US7Y.BOND":0.9,"US6M.BOND":0.9,"US5Y.BOND":0.9,"US30Y.BOND":0.9,"US2Y.BOND":0.9,"US12M.BOND":0.9,"US10Y.BOND":0.9,"FDN":0.79,"US912797FS14.BOND":0.6,"US912797GB79.BOND":0.6,"US912797GK78.BOND":0.6,"US912797GL51.BOND":0.6,"US912797GW17.BOND":0.6,"US912797HE00.BOND":0.6},"content_text":"Invesco Taxable Municipal Bond ETF is a passive ETF that tracks the performance of US dollar-denominated taxable municipal debt.The outlook for BAB is modest, with a potential for 2-3% returns, which is weak compared to inflation and cash offerings.Low levels of issuance in the taxable municipal bond sector could be a bullish catalyst for the Fund.JJ Gouin Main Thesis & Background The purpose of this article is to evaluate the Invesco Taxable Municipal Bond ETF (NYSEARCA:BAB) as an investment option at its current market price. The fund is managed by Invesco, and it is designed to \"track the performance of US dollar-denominated taxable municipal debt publicly issued by US states and territories\". This is a passive ETF, which is a contrast to most of the funds I normally review in this space, which are leveraged CEFs. Just over a year ago, I covered BAB and suggested investors take some profits after a strong run in the fund (and the underlying sector overall). I saw a more cloudy forward outlook and downgraded my view to \"hold\". In hindsight, this was a pretty spot-on assessment, as equities have roared higher and taxable munis have offered modest returns: Fund Performance (Seeking Alpha) Given the performance gap between taxable muni bonds and equities over the past year, I wanted to take some time to reconsider this outlook to see if maybe a shift was in the cards. After all, these sectors often move conversely with each other so, logically, if equities are about to run out of steam, perhaps BAB is a buy now. However, after review, I still see a modest environment for the underlying securities BAB holds. As such, I think reaffirming the \"hold\" rating makes sense, and I will explain why in detail below. Any Positives? Low Issuance Is One To start, I will begin with some of the positives for those owning BAB or looking to buy it going forward. As mentioned, I think modest gains could be in the cards for this fund, so I am not an outright bear. However, a 2-3% return over a year is very weak in this environment - with inflation above that level and cash offering 5%! So seeing a positive return in the low single digits is nowhere near the \"alpha\" those of us on here want to achieve. Still, that doesn't mean there aren't any bullish catalysts for BAB. One is that the underlying securities are getting a boost from low levels of issuance in 2024. With interest rates elevated, many muni issuers are pumping the brakes on raising new funds - as that would require paying elevated borrowing costs to do so. Many municipalities and public works projects are resorting to tax increases and/or tolls and usage fees to cover costs, rather than issuing taxable munis for fundraising. The net result has been a steady decline in supply for this sector, as shown clearly in the graphic below: New Issuance - Taxable Munis (By Calendar Year) (Charles Schwab) The premise here is that as long as supply remains tight, underlying valuations are supported. That doesn't mean they can't go lower, but if demand is steady and/or picks up in the near term, then taxable munis are poised to rise. I personally don't view this as a strong enough possibility to be a bull year, but it again supports a moderate view of the sector. All things being equal, lower supply can be a tailwind for prices, and taxable munis have that going for them. Equities Could Be Stretched, Depends On Perspective The second reason for buying BAB right now could be that investors want an equity hedge. I personally remain an equity bull - with respect to large-cap US stocks. But that doesn't mean I am necessarily right. There are plenty of things to be concerned about at the moment and I wouldn't fault anyone for wanting to take some risk off the table with indices at or near all-time highs. There is plenty of forward risk in the market, and that opens up the door to buy munis - taxable or tax-exempt. The reason is that stocks are nowhere near value territory. In fact, according to a report from Morningstar out last month, the S&P 500 has a forward P/E that is higher than the vast majority of the time. That doesn't put value-oriented investors at ease one bit: Valuation Story (Morningstar) Further, there has been a rise in geopolitical tensions over the past year, with military conflicts in Eastern Europe and the Middle East making daily headlines. With these conflicts continuing to drag in the \"West\" - namely the U.S. and Western Europe, there is the potential for further escalation. Coinciding with this, trade protectionist policies have been ramping up. This puts fuel to the fire on some of the geopolitical issues currently at hand: Protectionist Trade Trends (Merrill) Add this all up, and who could blame someone for wanting to protect their portfolio with bonds? Taxable munis - and BAB by extension - are logical options since this sector has a low correlation with other areas that are deemed to be risk-on choices: Long-Term Correlations (Invesco) What this shows is that taxable munis are not correlated very strongly with anything outside of other IG-rated bonds. That gives it a lot of merit as a hedge and can come in handy when other sectors are under pressure. Whether that is going to be useful in the second half of 2024 is up for debate, and I personally don't see the need to go as long as this juncture. But others will disagree, and this is a supporting attribute for why BAB will stay on my radar going forward. Inflation, Risk-Free Rate Limit BAB's Attractiveness Now to shift gears, I will discuss some of the hurdles facing this fund. One in particular is what has been impacting BAB, and other fixed-income options, for a long time is inflation. The reality is that an elevated inflationary environment makes life difficult for bond investors because higher rates can depress bond prices and also offer investors attractive offers elsewhere. For example, BAB's current yield is around 5%. For those who remember the days of 0-1% interest rates, this can look good on the surface: Current Yield (BAB) (Invesco) While this could look reasonable, we have to remember the environment today is not what it was 10 years ago. For example, core inflation remains stubbornly high and that has limited the Fed's ability to lower interest rates to the point where a 5% bond yield is generating much of a real return: Core Inflation (US) (Bureau of Labor Statistics) The bottom line is that while inflation remains high and the risk-free rate is in the 5% range, buying bonds for that yield 5% has to be done under the assumption that the underlying prices are going to increase to turn a positive real return. In this current climate, that is a difficult argument to make because the Fed has continuously pushed back on the notion that rate cuts are coming soon. While they inevitably will, I think time is on our side here, and see no need to rush to bonds at these levels. This includes BAB, but also the many other options I cover holistically. While this dynamic will change at some point, I suspect investors have until Q3 or Q4 to make an entry into this arena and will not miss out on much of a real return until then. Heavily Concentrated In Two States Another modest attribute about this particular fund is it is overweight in the two biggest muni players in the country: California and New York: BAB's State Make-Up (Invesco) This isn't necessarily bad if this is the exposure you want, but if it isn't, you are getting a fund with over 1/3 of its bonds from just two jurisdictions. That is a fair bit of concentration risk that investors need to be aware of before they land on this option. Of course, since these bonds are taxable, it doesn't matter as much for California and New York residents to own this much exposure within their own state, so that limits the potential demand from these buyers who are normally very active in the tax-exempt muni sector. This is where some of the subjectivity comes in. If one resides in California, then they are probably better off buying a tax-exempt security or fund rather than something like BAB - even though it has mostly California bonds in it. The logic being the tax savings are probably greater than the after-tax yield offered in this ETF. However, for those outside California or in low tax brackets, then perhaps this dynamic is less of a concern. To understand where you sit as an individual, the following tax table could help: Yield's Bracket (Accounting for Taxes) (Marcum Accountants) The point here is everyone's tax situation is different and therefore the view on both California taxable munis - and BAB as a result - will differ based on their unique situation. This isn't a right or wrong, but for someone like me who is in a high tax bracket and resides in North Carolina, a fund with taxable bonds from California and New York offer a suspect value proposition. I need to see a compelling case to be a buyer, and that isn't what I see for the time being. The Biggest Thorn: Refundings Causing Losses The final point I want to touch on is one that has an ongoing debate raging within the taxable muni bond sphere. This is the ability of issuers to exercise what is known as an \"extraordinary redemption provision\" (ERP) and refund their taxable munis into tax-exempt securities without paying a \"make whole\" price to investors. The net result is savings to the issuer, and a potential loss for bondholders. This means those who own BAB stand to face losses if more and more issuers opt to exercise this provision going forward. What is this, and why does it matter? First, understand a \"make-whole call\" is an investor protection against potential losses when an issuer opts to pay off its debt early - which they often do in the taxable muni space in the form of refundings. This means calling the bonds and then reissuing new bonds at lower yields, often in the tax-exempt sphere. The result can mean cost savings for municipalities and bond issuers, but obviously the investors have to eat what they would have earned had they been able to hold to maturity. The make-whole call provision means the issuer may have to make up the difference to investors, protecting them against said losses. However, issuers have been recently taking advantage of what is known as an ERP to avoid paying that make-whole cost. The matter at play here is that issuers are suggesting the government's sequestration of BAB's subsidies (which began in 2013) is indeed an ERP. To understand what this is, consider that when BAB bonds were first issued, the government subsidized up to 35% of the cost - in order to spur issuance. Since 2023, this subsidy has been on the decline, driving up costs for issuers: Decline in Subsidies (The Baker Group) I would agree, based on the continual decline, that this could be an ERP and allow issuers to refinance as a result of it. But those who stand to lose out from this thesis have challenged it, in court. For now, the courts have sided with the issuers. There are a lot of moving pieces here, but the court ruling I am referring to is from The Indiana Municipal Power Agency case, which supports the conclusion that sequestration resulted in a \"materially adverse change to the cash subsidy payment obligation\" - meaning the ERP can indeed be utilized. While that law interpretation continues to be challenged by investors - the appellate court has made its verdict. If this gets appealed higher, the \"final\" verdict isn't out yet, but for now, issuers have proceeded with such refundings without paying those make-whole provisions. Again, this rule is being challenged, and I don't know what the ultimate outcome will be, but for now, the court's ruling has allowed issuers to take advantage of this dynamic. This means taxable muni bond investors face a unique risk that isn't present in other fixed-income sectors. So it is difficult for me to get behind this particular sector - and BAB by extension - when such a significant headwind is present here and nowhere else. Bottom-line BAB has not kept pace with the broader bond market over the past year, and bonds as a whole continue to be pummeled by equities. Given I have a bullish take on US stocks going forward, it is hard for me to get behind this idea as an investment play in the second half of the year. I think equities make the most sense, but moving to the tax-exempt muni space would be my preferred choice to BAB anyway due to the potential tax savings and the fact that taxable muni bonds have a unique risk facing them in the form of court challenges that have been favoring issuers over investors.  As a result, I think a neutral or modest outlook on BAB and the taxable muni space continues to make sense. I would suggest to my followers they approach any new positions very carefully for now.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2442132368"}