Build America Muni Bond ETFs Hot For Now

April 10, 2014

The muni market—and BABs in particular—roared back in the first quarter, but can that last?

This blog is the first in a series of quarterly reviews on the state of the fixed-income ETF market. Each will focus on one fixed-income ETF category as defined by ETF.com’s ETF Classification System methodology and provide an overview of the state of the category and performance comparisons. The best-performing ETF from the best-performing focus/niche will be selected for further analysis of performance drivers.

The municipal bond market, driven by improvement in fiscal conditions in many localities, record-low issuance at a time of strong investor demand for tax-free bonds, and a somewhat benign interest-rate outlook, rose sharply in the first quarter, reversing what had been a pretty dismal 2013.

The Barclays Muni Bond Index is up 3.23 percent so far this year, outperforming the Barclays US Aggregate Bond Index by about 140 basis points. Even more impressive is the Build America Bonds (BABs) pocket of munis, one of the biggest losers in 2013, which is up this year three times as much as the Barclays Agg.

I’m going to explore some of the structural drivers and macro factors that affect BABs and related ETFs. The economy is improving but, it seems, in fits and starts. That means that while rates are moving higher toward historical norms, the exact path and time horizon are anything but certain. In my view, rates are likely to move up gradually and unevenly across the yield curve with significant volatility.

Translation? Investors looking for a smooth ride may not have the stomach for munis.

In other words, because muni bonds have longer maturities and durations in general, the prospect of rising interest rates hits munis harder than other parts of the bond market. Specifically, the Barclays Muni Bond Index fell 3.1 percent last year, while the Barclays US Aggregate Bond Index lost 1.8 percent.

Remember that the muni market fell apart last year after former Federal Reserve’s Chairman Ben Bernanke whispered his now-famous remarks about the need to begin “tapering” five years of quantitative easing

Nowhere is muni duration risk—or duration advantage—of relatively long-dated munis more clear than in the BABs pocket of the muni market. The Barclays US Aggregate Build America Bond Index fell 5.8 percent last year, and this year is outperforming both the Barclays Agg and Barclays Muni Index on the way back up, as the two charts below show.

muni_index_perf_2013_v2

muni_index_perf_2014_v2

 

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