Why Muni Bond ETFs Look Ripe For The Picking

February 02, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Gary Stringer, president and chief investment officer of Memphis, Tennessee-based Stringer Asser Management.

The sharp decline in the bond market during the fourth quarter of 2016 created opportunities that made certain fixed-income sectors attractive, in our opinion, including an entry point for more interest-rate-sensitive securities.

For instance, high-yield municipal bonds now look favorable to us. Tactically, we believe high-yield municipals make sense due to attractive relative valuations and our expectation that long rates will remain range-bound over the near term.

The election created opportunities in the municipal market, as tax-free bonds have taken a hard hit on policy risks. Lower tax rates potentially hurt demand for municipal bonds, which creates less yield than similar-duration taxable bonds. The potential for lower demand at current rates has been priced in, in our view, pushing yields on municipals up faster than their taxable peers.

Tax Code Reform Brings Risk

However, any overhaul of the tax code could include a proposal to eliminate or reduce the tax-exempt status of municipal bonds, thus introducing more risk to the sector.

We think demand will remain strong for municipals, due to the increasing number of income-seeking investors as the retirement population continues to grow. Additionally, an improving economy should support spread levels in the sector.

Finally, it is highly unlikely the tax-exempt status of municipal bonds will be voted out since municipalities depend on the lower rates to finance the needs of the communities and states they support. An increase in the cost of debt to municipalities would create a huge burden.

Infrastructure projects, which are expected to have a big push from the Trump administration, are often funded with municipal bonds, which makes these projects less expensive to fund. At this point, the market may be oversold on fears of policy risk.

Spread Widening Is Good For Munis

The yield-to-worst on the Bloomberg Barclays High Yield Municipal Index stood at a little more than 6% on Dec. 30, 2016. While this equates to a taxable yield of more than 8% for an investor in a 33% tax bracket, it is still an attractive yield without the tax benefit.

Spread widening, which has occurred due to concern over tax reform, makes high-yield municipals even more attractive. This widening has pushed the price on high-yield municipals down faster than their taxable bonds counterparts.

 

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