BBN: Optimistic Outlook Fades For Taxable Muni Fund That Has Been Outperforming Equities – BlackRock Build America Bond Trust (NYSE:BBN)

Main Thesis

The purpose of this article is to evaluate the Taxable Municipal Bond Trust (BBN) as an investment option at its current market price. This is a fund I heavily recommended last quarter, and it has performed extremely well. While I typically advocate buying tax-exempt muni bonds, the taxable muni bond sector has seen a sharp uptick in activity since the middle of last year. As interest rates declined and municipalities rushed to refinance, they were forced in to the taxable sector due to limitations of muni refundings in the 2017 tax reform bill.

Despite not having the tax-advantages of their tax-exempt counterparts, funds like BBN have been seeing strong gains in the short-term as investors have been on the hunt for yield wherever they can find it. With BBN’s yield in excess of 5%, it has seen a lot of investor interest, especially among non-US investors who are not concerned with savings on US taxes. Looking ahead, I see BBN continuing to hold up reasonably well, although I don’t expect it to continue to beat out equities. Supply is on the rise, which will pressure total return, although I expect robust demand to continue, which will limit some of this pressure. Furthermore, while BBN’s valuation is not nearly as attractive as when I last recommended it, the fund’s market price still sits just under its NAV, which is reasonable given that many muni funds trade at premium prices. Finally, BBN holds a large portion of non-callable bonds. This is critically important given our low interest rate environment, as it limits the refinancing risk investors in the fund face.

Background

First, a little background on BBN. The fund is managed by BlackRock (BLK), and its objective is to “seek high current income, with a secondary objective of capital appreciation”, primarily through to exposure of taxable municipal bonds. Currently, BBN trades at $25.52/share and yields 5.26% annually, paying monthly distributions. I covered BBN a few months ago, and recommended it. In hindsight, this was a good call, as the fund has seen a strong return since then:

Source: Seeking Alpha

With 2020 underway, I wanted to do an updated review of the taxable muni bond sector, and BBN by extension, to see if I should change my outlook from here. While I still like the fund and believe it is a solid buy, I expect returns will be a bit more modest going forward. Simply, if the market continues to push higher, I do not expect BBN to out-perform equities as it has been now. Therefore, I believe a more “neutral” rating on BBN is appropriate, and I will explain why in detail below.

Yields Are Low, But BBN Has Mostly Non-Callable Bonds

To begin, I want to highlight a key development impacting the muni bond sector as a whole, but specifically related to taxable bonds. This has been refinancing activity, as the sector saw spike in this type of issuance last year. The reason behind this has been declining interest rates, which has contributed to declining yields within the fixed-income world, including for the muni bond sector. As the Fed cut rates in 2019, investors flocked to lock in yields, pushing up the price of the bonds and simultaneously pressuring yields. As muni demand has remained strong, even under this environment, the result is yield spreads are sitting at levels below historical norms, as shown below:

Source: Bloomberg

While investor demand has been one positive reason for the declining yields (in terms of total return), the Fed action to lower rates last year has also contributed. Simply, municipalities did not want to wait any longer to refinance outstanding bonds, and acted to lower their borrowing costs in case rates did not decline further. However, this was especially impactful to the taxable muni bond sector. Due to refunding limitations in the 2017 tax reform, municipalities that refinance outstanding bonds have to reissue them as taxable bonds. Essentially, these municipalities lose out on the benefit of being able to issue tax-exempt debt. However, investor demand has been strong enough for both tax-exempt and taxable munis, and municipalities have ultimately decided the refunding option was worth it. To illustrate, consider the increase in refunding activity in the muni market last year, compared to 2018, as shown below:

Source: Goldman Sachs Asset Management

Clearly, the impact has been substantial and that can have two key implications with respect to BBN and funds like it. One, the increase in new supply could pressure the underlying value of existing bonds and two, the current yield could drop as existing bonds are being replaced by news ones at prevailing (lower) rates. The overall impact of this could be lower yields and lower prices, neither of which is good news for current investors.

On this backdrop, why would someone want to invest in BBN? For this point, we need to look at the characteristics of the actual holdings within the fund. While the developments I noted above do indeed impact the broader taxable muni bond sector, BBN’s set-up should limit the impact of what is going on in the market. Specifically, consider that the majority of the fund’s bonds are actually non-callable. To illustrate, view the fund’s make-up below, which shows almost two-thirds of the bonds are considered non-callable:

Source: BlackRock

My point here is that while existing bonds, and the funds that hold them, are indeed at risk of seeing those bonds get refinanced before maturity, BBN’s make-up limits this risk in a big way. The impact would be that the fund’s bonds will continue to stay on the books at current yields, which is a big win for investors as alternative ETFs and CEFs without this feature would likely see their yields drop sooner, and by larger amounts.

My takeaway here is this presents a good case for buying BBN, despite the headwinds facing the sector. While the fund does have a good chunk of bonds, almost 20%, that could be called within one year, the high percentage of non-callable bonds will limit the overall impact of further muni bond refinancing activity on this particular investment.

Supply Is High, Which Will Pressure Existing Prices

My second point will be to touch on the issue of supply, which I noted above. While I just highlighted a key characteristic that I believe will help BBN hold up well in our current environment, the issue of rising supply will likely have an impact on the fund, even with a high amount of non-callable exposure.

To see why, consider that existing taxable muni bond supply greatly increased in the second half of 2019. While refinancing activity has taken a breather in the new year so far, the amount of outstanding taxable muni bonds remains above the average level for the past three years, as shown below:

Source: Bloomberg

My point here is that while the underlying prices of taxable bonds have remained high because of robust demand, an increase in the amount of supply outstanding does pose a headwind for the sector. So far, demand for this rising level of supply has been easily met, but that might not always be the case. If demand slows, or supply rises even higher, this will pressure the underlying value of the bonds within BBN. While this has not happened in the short-term, yet, it is a risk to be aware of and not totally discount.

My takeaway here is this reality helps support my “neutral” rating now, as opposed to a more optimistic view. When we couple rising supply levels with the fact that BBN has registered strong gains over the last few months, getting a bit more cautious here seems to make sense at this time.

Current Market Price Still Shows Slight Discount To NAV

My next point also has a positive slant, but with a bit less optimism that a few months ago. When looking at CEFs, especially in the muni bond space, valuations can swing wildly from one fund to the next. As a long time investor in PIMCO CEFs, many of those muni funds have been sustaining quite large premiums, which makes me generally unwilling to add to positions now. One attribute that originally attracted me to BBN was that the fund actually traded at a discount to NAV. As the fund has performed well since my last review, this discount has essentially been eliminated, which makes my forward outlook less optimistic. However, the fund still trades essentially at par, so it is more attractive compared to funds at premiums. Further, a reason for this reasonable valuation has been the fund’s NAV growth. In just a two month time period, the NAV has risen almost 5%, as shown below:

NAV in December Review Current NAV NAV Gain
$24.39/share $25.58/share 4.88%
Current Market Price Current NAV Current Premium to NAV
$25.52/share $25.58/share (.24)%

Source: BlackRock

My takeaway here is BBN’s market price doesn’t represent a screaming buy opportunity here, but it is still a very reasonable option compared to many alternative products within the muni space. When we couple a valuation at par with a generally positive outlook on the taxable muni sector as a whole, new entries now could make plenty of sense.

Foreign Demand To Remain High For US Fixed-Income

A final consideration reiterates a point that I made during my last review. Specifically, foreign demand for taxable muni bonds has been high, and this was a catalyst I saw providing further gains for the fund. In hindsight, this has indeed come to fruition, as foreign interest has helped BBN register a strong gain in the short-term. Looking ahead, I see a market environment where this buying continues to be a tailwind for the fund.

To see why, consider a key reason why non-U.S. investors are interested in taxable munis, or in U.S. fixed-income in general. The reason is many government bonds in other countries are actually offering negative yields, which is a phenomenon that some thought would exist temporarily, but has actually accelerated to round out 2019. To illustrate, consider the amount of bonds outstanding with negative yields on a global level, as shown below:

Source: Wall Street Journal

Clearly, global bond investors are facing quite a bit of negative yielding debt. Furthermore, while many government bonds across Europe are still in positive territory, the yields are still quite low, as shown below:

Source: Bloomberg

The takeaway here is similar to what it was back in December. This yield story provides quite a bit of incentive for residents in those impacted countries to search for yield elsewhere, which is leading many of them directly to U.S. munis. While many U.S. investors may focus on tax-exempt munis, foreign investors do not have the same goals in this regard. With taxable munis offering yields well above what European government bonds are offering, U.S. investors may want to consider this sector to get in ahead of continued foreign demand that I expect to see throughout 2020.

Bottom-line

BBN has been one of my better calls heading in to 2020, and I continue to see merit to owning it. The fund’s non-callable holdings should limit the pressure on the current yield in the short-term, demand for muni bonds remains high, and foreign interest should continue to drive gains to the sector. While these are positive factors, investors need to consider rising supply as a potential headwind, and consider that BBN’s valuation is not nearly as cheap as it was last year. Therefore, I see BBN holding up reasonably well going forward, but expect to see more modest gains in the short-term than what was registered over the last two months. In sum, a “neutral” rating on BBN is appropriate, and I would suggest investors carefully consider new positions at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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