A Solid Choice for Broad Exposure to the U.S. Muni Market

Suitability

Because municipal-bond interest is exempt from federal taxes, municipal-bond funds are most appropriate for investors seeking tax-exempt income--particularly those in high tax brackets--and fit best in taxable accounts.

High-profile bankruptcy filings in Detroit, Michigan (2013), and Stockton, California (2012), and, more recently, the substantial financial stress in Puerto Rico and the state of Illinois have increased volatility in the municipal-bond market over the past several years. Widespread credit concerns have largely subsided, however, as fundamentals have improved across the muni market in 2014 and 2015. Importantly, the fund does not have exposure to Puerto Rico or Stockton, and minimal exposure to Detroit (0.02%), which reduces its actual credit-risk exposure.

Municipal-bond yields are generally lower than those that their taxable counterparts offer because of their tax benefits. As of March 21, 2016, the fund had a weighted average yield to maturity of 1.73% and a tax-equivalent yield to maturity of 2.86% for investors in the highest (39.6%) tax bracket. A muni-bond fund’s tax-equivalent yield is the yield that a taxable-bond fund would need to offer to equal the muni-bond fund’s tax-exempt yield for an investor at a specified income tax bracket. This fund’s recent tax-equivalent yield to maturity exceeded the yield of the Barclays U.S. Aggregate Bond Index (2.27%). Thus, the fund’s competitive yield and tax advantage versus taxable-bond funds may make this a compelling choice for investors.

Fundamental View The fund weights its holdings by market capitalization, which means that the most heavily indebted municipal issuers receive the largest weightings in the portfolio. This weighting approach could increase credit risk because issuers with the heaviest debt burdens, like California and New York, may be more susceptible to ratings downgrades. However, the fund's focus on investment-grade bonds helps mitigate credit risk.

For most of the past three years through the end of 2015, heavily indebted states like New York and California have slowed the growth of new debt and boosted tax revenue. At the same time, unemployment in these states has continued to decline toward the national average. Those trends have helped calm municipal-bond fund investors’ concerns over the states’ ability to pay their interest obligations.

While the economic recovery since 2008’s crisis has been slow, municipal strength has been increasing steadily. A December 2015 analysis by The Pew Charitable Trusts found that real tax receipts adjusted for inflation in 29 states had recovered by the second quarter of 2015 from declines experienced during the Great Recession. The State Revenue Report dated November 2015 by the Nelson Rockefeller Institute of Government shows that 47 states experienced growth in tax receipts in fiscal 2015. In particular, California saw 11.7% growth, driven by strong personal, corporate, and sales tax. New York saw a moderate tax receipt growth of 5.0%, despite continued weakness in the state’s corporate-tax sector.

California currently has an average credit rating of AA-, while New York has an average credit rating of AA+. Texas, the third-largest geographic area represented in the fund’s portfolio, has an average credit rating of AAA. These ratings imply a low risk of default.

As of March 2016, the fund had a shorter duration (4.7 years) than the Barclays U.S. Aggregate Bond Index (5.5 years), indicating that it is less sensitive to interest-rate changes than the broad benchmark. For every 1% increase in interest rates, investors can theoretically expect a 4.7% and 5.5% loss, respectively, though other factors beyond changes in interest rates can affect the performance of municipal-bond funds.

Portfolio Construction The fund tracks the S&P National AMT-Free Municipal Bond Index, which measures the U.S. investment-grade tax-exempt municipal-bond market and excludes bonds subject to the Alternative Minimum Tax. Bonds must be a constituent of a deal that originally amounted to at least $100 million at offering and have a minimum par amount of $25 million. Bonds issued in U.S. territories, including Puerto Rico, are excluded. The index weights its holdings by market capitalization and rebalances at the end of each month. Nearly 80% of the benchmark's constituents have an average credit rating of AA- or better. The fund holds bonds from 44 states. Issuers from California (22.6%), New York (19.5%), and Texas (9.4%) comprise the three largest groups in the fund's portfolio. The bonds are issued by state and local governments and proceeds are used to finance a variety of projects including those focused on transportation (14.9%) and utilities (15.8%).

Fees The fund has an expense ratio of 0.25%, which is among the lowest of its exchange-traded fund peers and compares favorably with the 0.75% average expense ratio of open-end mutual funds in the municipal intermediate broad Morningstar Category. Over the trailing three years through February 2016, the fund has trailed its bogy by 0.16% a year, which is below its 0.25% fee.

Alternatives

MUB is far and away the largest and most-liquid intermediate-term municipal-bond ETF. The second-largest intermediate-term municipal-bond ETF is

Investors looking for even longer duration (7.6 years) municipal bonds might be interested in

Investors looking for a lower price tag might consider

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