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.com 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.
Funds With Even Shorter Duration Exposure
Investors seeking shorter duration exposure may wish to look at the VanEck Vectors AMT-Free Short Municipal Index ETF (SMB) as well as the iShares Short-Term National Muni Bond ETF (SUB) and the PIMCO Short Term Municipal Bond Active ETF (SMMU), all of which have shorter durations and reasonable dividends.
The VanEck Vectors Pre-Refunded Municipal Index ETF (PRB) invests in prerefunded munis, so because of the very high credit quality, the dividends are lower than from some of the other short-term muni ETFs. However, the very high quality can also serve to offset credit risk exposure for investors with heavier allocations to muni high yield, such as the VanEck Vectors High-Yield Municipal Index ETF (HYD) and the SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB).
(For overall portfolio diversification, it can make sense to have a small portion of the fixed-income allocation invested in high yield, and because the exchange listing and share prices are much lower than for individual bond lots, investors can more easily fine-tune their high-yield exposure with ETFs.)
Most long-term investors don’t have the luxury to withdraw from the market or to wait for the Fed or more predictable times. Municipal bonds remain a key component of the portfolios of many investors, and ETFs are an increasingly popular way to access the muni market. For muni investors who have been waiting and are ready to get into the market, please start by reading How to Pick The Right Muni ETF.
How much duration is too much? Modified duration provides an estimate of how much a bond or a portfolio will move in price for an immediate 1% change in interest rates. For example, if an ETF had a duration of 5.0, it would be expected to decline in price by 5% if there were an instantaneous 1% increase in interest rates. Duration is only an estimate, and the actual change in market price will be affected by many factors, but the measure can be a helpful tool for comparing interest-rate risk exposure between bonds or portfolios.
As a point of reference, based on current benchmark rates and assuming new purchases of all par bonds, a hypothetical 10-year laddered high-grade (double or triple “A”-rated) portfolio right now would have an average weighted duration of 5.2, while a 15-year laddered portfolio would be 7.2. While it is possible to take on more duration than you may be comfortable with, it is also possible to take on too little.
Patrick Luby is a municipal bond portfolio strategy specialist and the author of www.IncomeInvestorPerspectives.com. He will be a speaker at the Inside ETFs Inside Fixed Income Conference in Newport Beach, California, Nov. 2-3.
First-half holders data are from the Federal Reserve Quarterly Flow of Funds Report, Sept. 16, 2016.
At the time of writing, the author held none of the securities referenced. This is not a recommendation to buy, sell or hold any of the securities or strategies mentioned. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Information is based on sources believed to be reliable, but its accuracy is not guaranteed. Additional information is available upon request.