[This industry perspective is sponsored by VanEck.]
VanEck launched its first municipal bond ETFs more than a decade ago, and they were among the first such products to come to market. VanEck municipal bond Portfolio Manager Jim Colby, and Senior ETF Product Manager Michael Cohick discuss why investors should care about munis, and how they can use VanEck’s suite of muni ETFs in their portfolios to potentially capture both the performance and tax-exempt income in this foundational asset class.
VanEck has a very broad and deep municipal bond ETF suite. Would you give me an overview of the philosophy behind VanEck’s muni ETF lineup?
Jim Colby: Twelve years ago, the firm was seriously considering the launch of fixed-income ETFs. Our research, along with my professional experience in the industry, indicated a strengthening appetite from investors for a more attractive way to access tax-exempt income. The result was our customized suite of municipal bond ETFs.
Investors have both individual goals and risk tolerances. When it comes to fixed-income investments, the latter usually include exposure to interest rate and credit risk and, when it comes to the former, we believe income investors generally seek the highest yield available. As we developed our muni fund offerings, we decided they should and would address these goals and concerns.
VanEck provides access to the municipal market in three fundamental ways. One way is via the yield curve for investment-grade municipal bonds. Here we have three ETFs: short—VanEck Vectors® AMT-Free Short Municipal Index ETF (SMB®), intermediate—VanEck Vectors® AMT-Free Intermediate Municipal Index ETF (ITM®), and long—VanEck Vectors AMT-Free Long Municipal Index ETF (MLN). The second way is via credit quality. We “bookend” credit with a short-term high-yield muni ETF, VanEck Vectors Short High-Yield Municipal Index (SHYD), and an all-maturity high-yield muni ETF, VanEck Vectors High-Yield Municipal Index ETF (HYD®). And the third is through smart beta1—VanEck Vectors® CEF Municipal Income ETF (XMPT®) is a fund-of-funds that offers investors a smarter way to access the higher-yield potential that is unique to municipal bond closed-end-funds.
We believe municipal bonds are and should be a fundamental part of taxpayers’ investment portfolios. Over time, investors typically look to adjust their outlook and opportunities for return in response to changes in tax rates and income streams. Munis can provide something unique in this space: tax-advantaged income. Although they are not alpha generators, and as a rule, do not provide high rates of return, munis do provide steady income and returns as a result of that tax-advantaged income.
What has been going on in the municipal bond space lately? How should investors be looking at the space in the current market environment?
Colby: In November 2016, the fixed-income markets were really shaken by Donald Trump’s surprise presidential election victory. It led to uncertainties and concerns about taxes and policies. The prospect of increases in the budget and trade deficits, and the president’s assertion that his policies and programs were going to further stimulate the economy, led people to conclude that interest rates were going to rise. This would have a negative impact, at least temporarily, on bond values. The result: fixed-income instruments had lackluster performance in 2017.
However, it now appears we are experiencing a pause in the rate rising regime. This was confirmed by the recent U.S. Federal Reserve decision to hold rates steady for the remainder of the year, as well as evidence of tempering of economic growth.
Against this backdrop, I believe we are entering a period of calm and opportunity in the municipal marketplace. Investors appear to be feeling more confident about deploying cash into this market, not least as a result of pain being felt by taxpayers realizing the impact of the $10,000 cap on the deductibility of state and local taxes (SALT).
Since around the beginning of this year, the municipal marketplace has seen an uninterrupted inflow of cash.2 A resurgence in bond offerings, in contrast with last year’s drought, has seen new issues rapidly consumed by hungry investors.
Since the election, the market appears to have settled into more normal patterns, focusing on fundamentals, such as why tax-exempt bonds make sense for both institutional and individual investors. Year-over-year, that tax advantage coupon adds up, and continues to offer a steady balance compared with some of the more volatile asset classes.
Cohick: 2018 was a very odd year. Going into the year on the back of the tax changes, I think a lot of investors thought munis were going to be unattractive. The funds that did see inflows were short-term funds, and several new offerings were brought to market in that space. In the end, though, compared with other asset classes, municipal bonds performed strongly in 2018.
Source: Bloomberg Barclays. As of December 2018. For illustrative purposes only. Municipal bonds may be subject to state and local taxes as well as to federal taxes on gains and may be subject to alternative minimum tax. The chart displays the returns of the Bloomberg Barclays Municipal Bond Index and compares such returns to other asset classes as represented by market indexes. Please see full disclosures at the end of this article.
If people did miss an opportunity, I think it was in high yield, which was a particular high point last year when rates were less of a concern. For 2019, I think duration will be back in play. Based on flow data, it appears investors are going further out on the curve through yield, looking more to the intermediate and long end of the yield curve.
Why is duration so important right now?
Colby: Duration is an important metric for fixed-income portfolio managers and investors alike. It is a measure of interest rate sensitivity, and relates directly to maturity and interest rates: Generally speaking, the longer a bond, in terms of its time to maturity, the higher its duration.
However, munis generally tend to be far less volatile in their price movement, so comparing a bond in a corporate universe with a duration of 10 years to a municipal bond with the same duration is not exactly an apples-to-apples comparison.
As you might guess, the shorter the maturity structure of a bond ETF, the shorter its duration. Where there’s a bit of a departure from this is when you try to compare the duration of something like HYD (high yield) with any one of the three investment-grade funds in our muni suite.
High yield is a unique segment of the muni asset class, with specific attributes that differentiate it from investment grade. Although we calculate duration measures for the bonds that go into HYD, their behavior evidences a different sensitivity to markets from that of investment-grade bonds. The high-yield bonds are a little less well-known, less liquid and less frequently traded. But the attraction of enhanced tax-exempt income streams and surprisingly low default experiences appeals to a broad spectrum of investors.
Cohick: Another reason for the focus on duration is because, further out on the curve, where duration is longer, we see current opportunity. The 2018 rising-rate environment pushed investors into the short end. That has pushed yields down in that part of the curve, so it became over-bought and therefore rich in terms of relative value to Treasuries. This is an indicator often used by investors to determine where they should allocate.
Looking at the VanEck muni suite, how should investors be positioning themselves using the ETFs you offer?
Colby: First and foremost, we think investors should have munis in their portfolios. In terms of the fundamental opportunities, there is the tax-advantaged income and the historically low volatility of municipal valuations. Munis can be an anchor for portfolio building, and I think that is how individuals should think about munis as a whole.
Regarding our suite specifically, when we created this group of ETFs, our philosophy was to provide people with an opportunity to choose based upon their outlook. If they are concerned about rates, there are options for addressing their risk preference in the investment-grade spectrum. For example, more conservative investors may choose a short ETF, while other strategists may look at the long end of the muni marketplace, because they may think it has been underappreciated in terms of the value it represents.
Cohick: I believe our suite is distinct in the muni ETFs ecosystem in that it covers not only the yield curve, but the credit space, including both the full market as well as the short end. We see our funds as tools that can offer investors the ability to have control over their own portfolio exposures. Instead of buying an aggregate all-maturity national muni fund, like many other options available, investors can be much more targeted and specific, which gives them more control over the investment outcome.
We have also recently built an in-house municipal allocation strategy that uses both duration and credit risk factors in its inputs, in addition to relative momentum. Based on those inputs, our model provides an asset allocation that investors can implement using our funds. Currently, the strategy indicates an allocation to intermediate term (ITM), long term (MLN), and high yield (SHYD and HYD). For more information regarding the strategy, please see our fact sheet.
If you’re interested in learning more about the VanEck Vectors® suite of Municipal Fixed Income ETFs, you can subscribe to our Muni Nation insights at vaneck.com/munination.
The Bloomberg Barclays High Yield Municipal Bond Index is considered representative of the broad market for non-investment grade, tax-exempt bonds with a maturity of at least one year. The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt municipal bonds with a maturity of at least one year. The AAA and BBB indices are sub-sets of this broader index. The Bloomberg Barclays U.S. Treasury Index is the U.S. Treasury component of the Barclays U.S. Government Index. The index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more. The Bloomberg Barclays U.S. Aggregate Bond Index comprised of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity. The Bloomberg Barclays Global Aggregate Bond Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. The Bloomberg Barclays U.S. Corporate High-Yield Index covers 50 of the most liquid and tradable U.S. dollar-denominated, non-investment grade corporate bonds for sale in the U.S. The Bloomberg Barclays U.S. Corporate Index is the Corporate component of the Barclays U.S. Credit index. The index includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. The index represents the union of the US High Yield, the Pan-European High Yield, and Emerging Markets (EM) Hard Currency High Yield Indices. The high yield and emerging markets sub-components are mutually exclusive.
Fixed income investments have interest rate risk, which refers to the risk that bond prices generally fall as interest rates rise and vice versa. U.S. government bonds are guaranteed by the full faith and credit of the United States government. Municipal, corporate, agency and mortgage-backed bonds are not guaranteed by the full faith and credit of the United States and carry the credit risk of the issuer. Municipal bonds are exempt from federal taxes and often state and local taxes. U.S. Treasuries are exempt from state and local taxes, but subject to federal taxes. Other securities listed are subject to federal, state and local taxes. Prices of equity securities change in response to many factors, including the historical and prospective earnings of the issuer, the value of its assets, general economic conditions, interest rates, investor perceptions and market liquidity. Prices of bonds change in response to factors such as interest rates and issuer’s credit worthiness, among others. Investing in smaller companies involves risks not associated with investing in more established companies such as business risk, stock price fluctuations and illiquidity. Historical information is not indicative of future results; current data may differ from data quoted. The listed indices are unmanaged and are not securities in which an investment can be made.
This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third-party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
The VanEck Municipal Allocation Strategy is based on a proprietary account seeded on 1/1/2018. The allocation strategy is provided for informational purposes only and is currently not available for sale to the public. Please see our fact sheet for more information regarding this strategy.
Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer’s financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Bonds and bond funds will decrease in value as interest rates rise. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds. Please see the prospectus and summary prospectus of each Fund for more complete information regarding its specific risks.
The income generated from some types of municipal bonds may be subject to state and local taxes as well as to federal taxes on capital gains and may also be subject to alternative minimum tax.
Diversification does not assure a profit or protect against loss.
Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of a fund carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
1. A smart-beta ETF is a type of ETF that uses alternative index construction rules instead of the typical cap-weighted index strategy, in a transparent way. It takes into account factors such as size, value and volatility.
2. Lipper U.S. Fund Flows, as of 3/13/19.