Municipal bond ETFs should be well-positioned to weather an environment of rising interest rates.
As the market braces for the Federal Reserve’s first rate hike in more than six years, muni bond issuance has been at a record high, reaching nearly $220 billion this year. That massive supply spike came as investors opted to stay sidelined and build up cash reserves waiting for the Fed to take a stance.
But now, these bonds, which have mostly been issued to refinance older, higher-coupon bonds, according to data provided by Cumberland Advisors, are attracting renewed interest thanks in part to the attractive yields they are shelling out. A strong performance is also bringing back investor demand.
Assets Flowing In
In October alone, muni ETFs raked in nearly $600 million in new assets. The iShares National AMT-Free Muni Bond ETF (MUB | B-79)—the largest muni ETF in the market, with $5.5 billion in assets—has gathered nearly $1.5 billion in fresh net assets so far this year. In the high-yield space, the Market Vectors High-Yield Municipal ETF (HYD | C-59) has seen net inflows of $200 million. HYD has $1.65 billion in total assets.
And consider this: Vanguard, the second-largest ETF issuer in the U.S. today, had only one ETF launch in 2015, and it was a muni fund—its first. The Vanguard Tax-Exempt Bond Index (VTEB) hasn’t been in the market three months yet, and it has $67 million in assets.
As John Miller, co-head of fixed income at Nuveen Asset Management, recently summarized in a webcast: Returns year-to-date are positive across the curve, and it’s income that’s driving returns. Moreover, munis’ tax exemption has also been “increasingly valuable” to investors, and “the stability and low correlation to other asset classes has been a hallmark of the municipal market so far this year,” he says.
“All those features should be attractive to keep people engaged and keep performance up,” he added, noting that the fourth quarter could be the muni market’s best in 2015.
So far this year, muni ETFs have outperformed long-dated Treasury bonds, all the while delivering nontaxable yields.
Chart courtesy of StockCharts.com
Why Should You Consider?
Here are five reasons you should own munis, according to market insight from Cumberland Advisors:
1. Yields are very attractive
“The ratio of long-maturity tax-free yields to U.S. Treasury yields has been very compelling this year,” said John Mousseau, Cumberland Advisors’ director of fixed income.
“Many AA-rated revenue bonds have offered 4 percent yields, which has been a yield ratio to Treasurys of over 130 percent. Yield ratios for triple-A issues has been over 100 percent,” he said.
Going forward, if interest rates rise, munis should offer enough of a yield cushion to “buffer performance.” As rates rise, bond prices typically fall. And that yield cushion is tax exempt.
2. The return outlook is positive
“Overall, we expect municipal bond finances to continue to improve,” Mousseau said. “We also expect the cheapness in the muni market will not be there by the end of 2016.”
According to him, slowly rising short-term interest rates should translate into an increase in taxable interest rates in the mid- to longer-end yield curve. But in the muni market, longer-term tax-free yields “will likely move sideways, or perhaps drop.”
Lower yields typically go hand in hand with higher bond prices.
3. Munis are a great diversifier
At the height of the financial crisis in 2008, when short-term funding all but evaporated, yields on general obligation and revenue bonds increased by about 20 percent—or 100 bps—each, according to Cumberland data. Meanwhile, yields on high-grade corporate debt rose 50 percent—or 300 bps. These numbers show that in time of serious stress, investors chose munis over corporates.
“Muni bonds’ separation from the more ‘institutional’ credit asset classes makes them that much more important as a source of noncorrelated risk,” he said. “Municipal bonds increase portfolio diversification.”
4. Infrastructure needs will keep muni issuance up
Bank holdings of muni debt have grown from $100 billion a decade ago to $500 billion in 2015, expanding municipalities’ access to capital significantly, according to Cumberland data.
“For most of the last year, the muni market has been dominated by refinancings, both current refundings and some advance refundings,” Mousseau said. “Eventually, the municipal bond issuance calendar will be dominated by new-money financings for the vast infrastructure needs of the country.”
5. Default risk is very, very low
Munis offer extremely low default risk. In fact, in the past 40 years, only 0.08 percent of investment-grade munis have defaulted, versus 2.81 percent of investment-grade corporates, according to Cumberland. The only safer investment is U.S. Treasurys.
“Investment-grade corporate bonds are 35 times more likely to default than munis are. The high credit quality of municipal bonds is indisputable,” Mousseau noted.
Contact Cinthia Murphy at email@example.com.