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Muni ETFs Battered, But Could Offer Value

Cinthia Murphy

Investment-grade municipal bond ETFs took a beating following last November’s presidential election, with some of the largest funds in the segment slipping to lows not seen since mid-2015.

That decline centered mostly on uncertainty—tax policy uncertainty, that is.

One of the big perks of muni bond investing is the tax-exempt status many enjoy, and any new administration can shake things up in the tax department.

Consider the trailing 12-month performance of some of the largest investment-grade muni bond ETFs, and the notable drop last November. The funds include:

Chart courtesy of StockCharts.com

“U.S. munis are a hot topic because of the Trump uncertainty—it’s all about taxes,” said J.R. Rieger, managing director and global head of fixed income at S&P Dow Jones Indices. “Even if you put aside all the risks associated with bonds, there is also the tax risk impacting muni bonds.”

According to him, there are two main areas of concern when it comes to munis and taxation. First, will the new administration change in any way munis’ tax exemption?

Secondly, what will other bonds be taxed at? For instance, could taxable interest on corporate bonds be lowered?

“It’s hard to forecast how and what tax changes will be made,” Rieger said. “Historically, there’ve been attempts to change tax exemption on muni bonds before, but they’ve all met with early demise. Still, there’s uncertainty.”

The good news is that, at least from a valuation perspective, the muni market “got hit so hard in November” that there’s an “opportunity” for investors to enter the space at attractive prices now, Rieger says. Investors looking for investment-grade, tax-free debt might find the muni space prime for picking.

“In the current environment, investment-grade tax-exempt munis are cheap relative to other asset classes, such as corporates. They are attractive,” he added.

Range-Bound Outlook

But the upside could be limited. Investors looking at the muni space might be bracing for range-bound price action in the months ahead because there are too many forces at play in the bond market.

In a commentary on the outlook for U.S. corporate and muni bonds in 2017, Rieger noted that this uncertainty surrounding taxes could keep a lid on muni bond prices. Ample supply is another issue. Municipal bond requests recently hit a four-month high, he notes.

On the flip side, many investors have turned to munis as their risk-off trade of choice. If volatility picks up in the equity market, muni bond demand could see a boon, particularly from pensions and endowments that have turned to dividend-paying stocks rather than bonds for income. These pensions and endowments may return to bonds, looking to invest at higher rates.

The chart below shows all the forces impacting the U.S. corporate and muni bond markets, keeping the outlook in check:

Source: S&P Dow Jones Indices

Contact Cinthia Murphy at cmurphy@etf.com

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