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Tough Time Ahead for Muni Bond ETFs? - ETF News And Commentary

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The U.S. muni bonds market saw a stupendous rally in 2014, returning about 8.7% (per Wall Street). This made the investment category the third best following the S&P 500 and the Dow Jones Industrial Average. The performance also corroborates the three-year best of the muni market.


Compelling valuation of the segment after being beaten down in 2013, the demand-supply disparity, recovering fiscal health of many municipal bond issuers and higher demand of safer assets amid global growth worries made the space a winner.


Investors should note that munis are safer bets than corporate bonds and yield better than treasuries. Usually the interest income from munis is free of federal tax and occasionally even state taxes, making it particularly intriguing to investors falling in the high tax cohort, who look to cut their tax burden (read: Worried About Taxes? Check 3 Muni Bond ETFs).


In such a backdrop, many investors expected the munis to keep up their northbound trajectory even in 2015. With the Fed still having a patient attitude on the rate hike issue, the higher yield nature of the munis should quench the thirst for current income. But in reality, the expectation has failed investors (read: Is 2015 The Year for Municipal Bond ETFs?).


Credit Risks Looming large


So far this year, muni bond ETFs’ return has hovered in the range of 1.69% gains to a loss of 2.31% with more than half of the products in the munis space trading in red. The sentiment arguably soured on the questionable creditworthiness of some munis. Notably, on May 12, Moody's downgraded Chicago munis to the junk status. Standard & Poor’s and Fitch Ratings also downgraded Chicago’s fiscal health but stuck to investment grade.


Following Moody’s cut, federally tax-exempt Chicago bonds maturing in January 2033 were traded at the highest yield since issuance (per Bloomberg). Chicago and some of its associated units account for one of the biggest slices of the high-yield muni market, per Moody’s. So, this downgrade mattered a lot to investors who were insecure about the future of muni bonds ETFs.


To add to the woes, Puerto Rico – another big issuer of the muni bonds – is also accused of having high credit risks. Charles Schwab’s recent data suggests that Puerto Rico’s debt obligation reached as high as 95% of its economic output. This was surprisingly higher than 2.4% of the median debt load for the 50 U.S. states.


Notably, Puerto Rico also sports a junk status. As per Bloomberg, a few Puerto Rican bonds yield as much as 10% currently, which is way higher than 2.1% yielded by the AAA Municipal Index.


Buy the Dip?


With yields rising, tax benefits are looking more prominent. For example, a 10% yield translates into 18% (for high tax payers) after considering the tax exemption as noted by Bloomberg. Probably this is why Goldman Sachs Asset Management and Oppenheimer Funds Inc. raised their exposure in the Puerto Rico bonds following credit downgrade, unlike many of the other asset managers.


With a faster-than-expected Fed rate hike possibility looking dim, investors would definitely look for higher yields. Moreover, the valuation is still cheap for the muni bond ETFs. Market Vectors CEF Municipal Income ETF (XMPT), which has generated highest return of 0.65% so far this year, is trading at a P/E (ttm) of 5 times while the largest broader market ETF SPDR S&P 500 ETF Trust (SPY) is trading at a P/E of 18 times (see all muni bond ETFs here).


ETF Choices


Investors should know that Market Vectors High Yield Municipal Index ETF (HYD), XMPT, SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB) are some of the examples of high-yield muni bond ETFs which are leading the space presently. HYD yields 4.85%, XMPT about 5% and HYMB yields 4.48% as of May 29, 2015. So, investors having a strong stomach for risks might consider investing in these ETFs though default risks are lurking behind.

 

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SPDR-SP 500 TR (SPY): ETF Research Reports
 
SPDR-NU SP HYMB (HYMB): ETF Research Reports
 
MKT VEC-HY MUNI (HYD): ETF Research Reports
 
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