Muni Bond ETFs Face Rising Rate Headwinds

ETF Trends

Municipal bond ETFs, a favorite destination of conservative, income-minded investors and retirees, have dealt with some challenging headlines in recent months. It started with reports that politicians from both parties were mulling an alteration to the tax treatment of interest earned on municipal bonds.

Those talks surfaced as part of the contentious fiscal cliff negotiations. The issue of municipal bond taxation has resurfaced recently because President Obama’s recent budget proposal “would impose for the first time a federal tax on municipal bond income ,” according to Stephen Shapiro and Timothy Bishop for Investor’s Business Daily

Muni bonds survived the fiscal cliff issue and in 2012, muni bonds were a $3.7 trillion market, with $51 billion in new deposits, the most since 2009. However, rising interest rates could be the latest threat to the asset class. [Muni Bond ETFs Keep Tax Shelter Status For Now]

Part of the issue facing muni bond ETFs is duration, or a bond’s sensitivity to rising rates. Muni bonds typically do not reside on the highest end of the yield curve, but they usually do not make a home on the low end of the curve, either. For example, the iShares S&P National AMT-Free Municipal Bond Fund (MUB) has an effective duration of 6.24 years, according to iShares data.

Additionally, depressed yields on muni bonds and the corresponding ETFs have been seen as a threat to the group’s returns in 2013. Muni bond yields hit a 47-year low earlier this year. [BlackRock Cautious On Muni Bond ETFs]

Those low yields may increase the allure of high-yield muni bond ETF, but making that switch is not without duration risk for investors. The Market Vectors High-Yield Municipal Index ETF (HYD) has returned 3% this year, far better than MUB’s slightly negative performance, and the Market Vectors offering features a 30-day SEC yield of 4.55% compared to a tax-equivalent 30-day SEC yield of 2.96% on MUB.

While the yield sounds attractive, HYD could prove even more vulnerable than MUB in a rising rate environment because the former has an effective duration of 10.6 years and a modified duration of 10.1 years. Combine expectations for rising rates with the notion that municipal bankruptcies could jump and it is fair to say the near-term outlook for municipal bonds is fraught with challenges.

Market Vectors High-Yield Municipal Bond ETF

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ETF Trends editorial team contributed to this report.

Tom Lydon’s clients own HYD.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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