After a rocky start to 2018, the municipal bond market rallied to finish up as the fifth-consecutive year, and is up so far this year.
Demand for municipal bonds has been very strong. Expect that to continue as tax-paying individual investors (especially those in the high-tax states, such as California, New York, New Jersey and Connecticut) begin to understand the dollars-and-cents impact resulting from the new limitation on the deductibility of state and local taxes (the SALT deduction) from their federal taxes. The interest in tax-exempt income will go higher.
(We calculate that even with the reduction in the maximum federal individual income tax rate from 39.6% to 37%, the cap on the SALT deduction means the combined state and federal maximum effective income tax rates went up in seven states: California, Connecticut, Minnesota, New Jersey, New York, South Carolina and Wisconsin.)
Municipal Bond ETF Assets Grow
While the municipal bond market has long been dominated by the demand for individual bonds, the appetite for professionally managed products has grown and the market for muni ETFs has grown as well: Out of the 47 muni ETFs currently available, all but 10 grew in assets last year.
So far this year (through Feb. 13), 24 muni ETFs have grown in assets, while 12 have lost assets. The other measure of investor activity is trading, and year-to-date, the overall pace of muni ETF trading (based on market value traded) is more than 45% heavier than last year. (YTD average daily trading is running at $393 million, compared with $270 million per day in 2018.)
Green Returns Across Muni ETFs
For 2018, the majority of the muni ETFs had positive returns, led by the high-yield ETFs—which was the best-performing credit sector last year, and through the end of January, only two of the 47 municipal bond ETFs had negative total returns, and those two funds are ultra-low-duration funds that are most sensitive to the changes in short-term rates. (They were the Invesco VRDO Tax-Free Weekly ETF (PVI) and the First Trust Ultra Short Duration Municipal ETF (FUMB.)
In January, the top five most actively traded ETFs captured 71% of the total trading volume. In 2018, those five funds had 69% of total volume. They were the iShares National Muni Bond ETF (MUB), the SPDR Nuveen Bloomberg Barclays Municipal Bond ETF (TFI), the Vanguard Tax-Exempt Bond ETF (VTEB), the iShares Short-Term National Muni Bond ETF (SUB) and the SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF (SHM).
As we have suggested here before, tactical investors contemplating the use of a muni ETF as a tool for temporarily implementing a particular view may wish to focus on the largest and most actively traded muni ETFs, such as the ones listed above.
Investors seeking core “buy and hold”-type exposure to municipals through ETFs can expand their search to include some of the other funds, but should be mindful of their own future liquidity needs and be comfortable with the liquidity of any ETF they are considering.
With the market now pricing in a much lower risk of a 2019 rate hike by the Federal Reserve, some investors may be more willing to extend duration. However, our U.S. Strategy team sees "room for wage inflation surprises as 2018's strong employment growth has continued to tighten the labor market."
So, while tactical investors may see incremental yields available by extending within their duration targets as attractive, they should be prepared to be nimble should inflation indicators move higher.
Long-term buy-and-hold investors who have been underweighting duration may wish to move some of that to slightly longer durations where they can be comfortable that they are earning a positive real return (yield minus the inflation rate).
The Bloomberg BVAL triple-A municipal benchmark curve hits 2% around the 11-year maturity, so investors in lower-rated credits should expect to earn a positive real return, i.e., a yield higher than the 2% inflation rate, in the seven- to 10-year range, depending on credit quality and the state of issuance.
The chart below plots the 13 most actively traded municipal bond ETFs versus the Bloomberg triple-A rated municipal market benchmark yield curve. (The Invesco Taxable Municipal Bond ETF (BAB) is excluded, since it tracks the taxable municipal bond market.)
California: the iShares California Muni Bond ETF (CMF) or the Invesco California AMT-Free Municipal Bond ETF (PWZ); as of 2/13, the iShares National Muni Bond ETF (MUB) had 21% exposure to California bonds, and the SPDR Nuveen Bloomberg Barclays Short-Term Municipal Bond ETF (SHM) had 19% exposure.
New York: In addition to the iShares New York Muni Bond (NYF), these funds had at least 20% exposure to New York munis as of 2/13: MUB (23%), PWZ (26%), the Xtrackers Municipal Infrastructure Revenue Bond ETF (RVNU) with 23% and VTEB (20%, as of 12/31/18).
Other Interesting ETFs
Taxable municipal bonds: BAB
Infrastructure/revenue bonds: RVNU tracks an index of bonds secured by revenues from infrastructure projects, such as water and sewer, public power, toll roads, etc.
Short-term alternative: PVI invests primarily in variable rate demand obligations, which often pay higher yields than money market funds, but which are typically issued in denominations of $100,000, so this fund provides access to this product with much lower minimums
Patrick Luby is the senior municipal strategist with CreditSights Inc. For more information or feedback, please call us at 212-340-3840 or email us at [email protected]. This article is not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice. No part of this report may be copied, disseminated, reproduced or distributed without CreditSights’ prior written consent. CreditSights, a publisher of investment research, does not give personalized financial or investment advice, and therefore does not recommend the purchase or sale of financial products or securities. Recommendations made in a report may not be suitable for all investors.