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A Solid Corner of The Muni Market

This article was originally published on ETFTrends.com.

Even against the backdrop of four interest rate hikes by the Federal Reserve last year, some municipal bond strategies and ETFs delivered solid performances.

Take the case of the VanEck Vectors High-Yield Municipal ETF (HYD) . HYD, one of the largest high-yield municipal bond ETFs, returned 2.20% last year, or more than double the gain posted by the widely followed S&P National AMT-Free Municipal Bond Index. HYD seeks to replicate the performance of the Bloomberg Barclays Municipal Custom High Yield Composite Index.

“2018 was a trying year for both equity and bond markets, with just a fifth of the Morningstar categories posting gains. Within that exclusive winner's circle was the high-yield muni category, which returned just over 2%, making it the third best performing category for 2018,” according to Morningstar.

Munis also help diversify fixed-income portfolios. Investors who typically follow the Barclays U.S. Aggregate Bond Index will not have municipal bond exposure, so a muni bond ETF can complement core fixed-income positions.

What's Next for Municipal Bonds?

The $2.3 billion HYD holds over 1,800 municipal bonds and has a 30-day SEC yield of 4.25%, or nearly 200 basis points above the 30-day SEC yield on the S&P National AMT-Free Municipal Bond Index.

HYD is up modestly this year, but there are some risks to consider with high-yield municipal bonds.

“First, the high-yield muni market is small, fragmented, and generally less-liquid than the investment-grade muni space. Second, because many high-yield municipal indexes are market-cap weighted, they show pronounced tilts to Puerto Rico bonds and tobacco settlement authorities, which are some of the most prolific issuers of low-quality municipal debt,” according to Morningstar.

Related: Is it Still High Times for High Yield?

Municipal bonds issued by Puerto Rico account for just 1.30% of HYD's weight, but tobacco settlement bonds are the fund's second-largest exposure at 15.40%. Still, HYD is underweight Puerto Rico and tobacco settlement municipal bonds relative to the Bloomberg-Barclays High Yield Municipal index.

“In 2018, that index gained a boost from the outperformance of its Puerto Rico holdings, which returned 20%, driven by performance in the Commonwealth's Aquaduct and Sewer Authority bonds, which gained 30% as the authority cooperated with bondholders and narrowed its funding gap. This event was a surprise, and illustrates a third risk within this category: One-off events can have an outsize impact on the performance of high yield muni benchmarks,” notes Morningstar.

For more trends in fixed income, visit the Fixed Income Channel.