Tax-exempt munis are already at all-time highs, and are looking attractive ahead of ‘fiscal cliff.’
Muni ETFs are hitting all-time highs as the relationship between Treasury yields and muni yields continues to evolve.The yields on high-grade fixed-income securities have seen near-record lows since the start of the brave new QE world we’re living in, but munis in particular are getting an extra boost from tax-wary investors.
Of note, the two securities are often compared because they have similar characteristics, with the exception that munis are exempt from federal taxes, and often from state and local taxes as well.
But while municipalities rated triple-AAA are generally subject to the same risk factors as the U.S. Treasury—meaning the yields on the two instruments often move in tandem—munis are tax exempt, so their nominal yield is usually lower than the nominal yield on Treasurys even if after taxes the two yields are nearly equal.
What’s been happening is that since 2009, the average yield ratio between muni and Treasury securities has been 96 percent, which indicates that gross yields have been almost identical and, post-tax, munis offered greater yield than their Treasury counterparts.
But currently, the benchmark yield on 10-year municipal bonds rated AAA is 87 percent of the yield on 10-year Treasury securities. That particularly low average—compared with the post-2009 level of 96 percent—is only the beginning of the story behind muni ETFs’ rise.
A look back at 30 years’ worth of data would suggest that munis still have room to rally: For the nearly three decades preceding 2009, muni yields stayed within a range of 75 to 90 percent of Treasury yields.
What’s more, the relationship between Treasurys and munis is likely to settle at a new average once Congress decides what to do about future tax rates. All else equal, as tax rates increase, municipals become more attractive because of their tax-exempt status.
Which ETFs deliver municipal bond exposure most efficiently?
For broad exposure to municipals, it’s hard to beat State Street’s SPDR Nuveen Barclay’s Municipal Bond ETF (NYSEARCA: TFI). It offers a well-diversified basket of more than 350 securities for a very reasonable 0.23 percent price tag. Liquidity is ample as well: Nearly $5 million worth of shares changes hands most days. It tilts toward higher-rated securities.
Those seeking credit risk have other options as well. For them, Market Vector’s High-Yield Municipal ETF (NYSEArca: HYD) is a better option. Its weighted average credit rating, BB, is drastically lower than TFI’s AA+ and it has the yield to show for it: HYD returned 18 percent over the past year.
Lastly, for those looking to target the belly of the muni market, the Market Vectors Intermediate Municipal ETF (NYSEArca: ITM) offers exposure to more than 600 municipal bonds with maturities between six and 17 years, with an expense ratio of only 24 basis points. The fund has returned 9 percent over the past year and has enough liquidity for all but the largest investors.
Ultimately, the dynamic between municipal bonds and Treasurys is evolving, and although muni ETFs are hitting all-time highs, history says they have room to run.
And as Congress deliberates on the future of our taxes, which are bound to increase, municipals will continually look more attractive.
At the time this article was written, the author had no positions in the securities mentioned. Contact Spencer Bogart at firstname.lastname@example.org.