Muni Investors Haven’t Been Waiting On Fed

September 22, 2016

In the first half of the year, some of the largest existing holders of municipal bonds increased their investments in munis: Total individual ownership increased by $62 billion, bank portfolio ownership increased by $25 billion and insurance companies added $7 billion. Even nonmuni bond mutual funds added $9 billion of munis, and non-U.S. investors added $2 billion.

Individual investors, who dominate the muni market, have been shifting how they invest in munis, and have been taking greater advantage of muni bond ETFs.

First, some background. While muni investors have a reputation of being “buy and hold” investors, the reality is that, unlike with equities—which are perpetual securities—investors in individual bonds can only buy and hold for so long, because bonds mature, and at maturity, investors face the decision of how to reinvest.

This year, according to Bloomberg data, an estimated 8% of all muni bonds ($313 billion) will mature or get called away, and in the first half, redemptions were estimated to have totaled $166 billion.

Fewer Individual Muni Bonds Held

With the current interest rate environment and reduced bond market liquidity, it is not surprising that a growing amount of money was directed not to individual muni bonds but to managed solutions such as mutual funds and ETFs.

In fact, according to the Federal Reserve, in the first half of the year, household ownership of individual bonds actually declined by $15 billion, but because of the $73 billion increase in fund ownership, household exposure to municipal bonds increased by $62 billion.

Additionally, an increasing proportion of the money flowing into funds is going into muni bond ETFs. With only 4% of the asset base of muni bond mutual funds, muni ETFs so far this year have captured 10% of the inflows that mutual funds have received.

Balancing Risk With Duration

Because of the recent bond market volatility, investors with concentrations in long-duration muni ETFs may wish to consider if they want to reduce that exposure by shifting into shorter-duration ETFs or by adding some very-short-duration ETFs to balance out their interest rate risk.

Generally speaking, core exposure should be from the muni ETFs with average credit quality of “A” or better, and duration in the range of 3 to 8. The table below highlights several muni ETFs that fit those criteria.

Ticker Fund AUM 3-Month Return Dividend Yield Duration Credit Quality
SMMU PIMCO Short Term Muni Bond Active  $68.65M 0.20% 0.95% 1.81 A
SUB iShares Short-Term National Muni Bond  $1.11B -0.08% 0.77% 1.91 AA
PRB VanEck Vectors Pre-Refunded Muni $19.75M -0.28% 0.86% 2.47 AA-
SMB VanEck Vectors AMT-Free Short Muni  $271.55M 0.22% 1.13% 2.74 AA-
SHM SPDR Nuveen Barclays Short Term Muni Bond  $3.11B 0.07% 0.71% 2.82 AA
MUNI PIMCO Intermediate Muni Bond Active  $260.42M 0.30% 2.30% 4.69 A
MUB iShares National Muni Bond  $7.64B -0.10% 2.35% 5.47 AA-
VTEB Vanguard Tax-Exempt Bond Index Fund  $492.66M -0.09% 1.57% 5.47 AA-
PZA PowerShares National AMT-Free Muni Bond $1.38B -0.45% 3.23% 6.64 AA-
ITM VanEck Vectors AMT-Free Intermediate Muni  $1.61B -0.12% 2.18% 6.65 AA-

Source: FactSet data from the ETF Screener.

Among typical core muni ETFs, the PIMCO Intermediate Municipal Bond Active ETF (MUNI) seems to have been overlooked by the market, with only $19 million in year-to-date inflows, yet it has an intermediate duration (4.69) and positive three-month trailing returns.

Not shown in the table below are two new Van Eck intermediate ETFs: the VanEck Vectors AMT-Free 6-8 Year Municipal Index ETF (ITMS) and the VanEck Vectors AMT-Free 12-17 Year Municipal Index ETF (ITML). ITMS is expected to have a duration of 5.80 and ITML to have a duration of 7.3.


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