Muni ETFs: Low Yield Doesn't Mean Low Return

Municipal bond yields may be low, but the total returns for most municipal bond ETFs have been very strong—higher than some equity returns, in fact.

Sources: us.spindices.com and index.barcap.com
Data as of 7-29-2016

Bond market returns have been helped of course by the continuing decline in yields around the world, which have pushed bond prices higher.

In the municipal bond market—which is dominated by income-seeking individual investors—declining yields have historically sent buyers to the sidelines, but this year, investors have been adding significant amounts of new money to the muni market. 

Net flows into muni ETFs have already eclipsed last year's total. However, not all of the flows into muni ETFs have been in just the top income-producing ETFs. 

Looking at the flows into the top dozen muni ETFs (which represent 90% of the total year-to-date muni inflows) illustrates some of the different reasons why investors buy municipal bonds: income, diversification and safety.

Income

Three of the top 12 ETFs rank high in dividend income: The VanEck Vectors High-Yield Municipal Index ETF (HYD), the SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB) and the PowerShares Build America Bond Portfolio (BAB) all have a dividend yield higher than 4%. (BAB invests in federally taxable Build America Bonds, making it potentially appropriate for tax-deferred and tax-exempt accounts.)

While HYD and HYMB have generated high levels of dividend income and have been inversely correlated to the SPDR S&P 500 ETF Trust (SPY), there are other muni ETFs that have been better portfolio diversifiers.

Diversification

Bonds are frequently used to add a counterbalance to equity risk, so that a balanced portfolio will (hopefully) show less volatility than an all-equity portfolio. Comparing the muni ETFs to SPY (as a proxy for equity risk exposure) reveals that almost all muni ETFs have been negatively correlated over the last six months; yet some muni ETFs have been better diversifiers than others.

Among the top dozen asset attractors, BAB, the SPDR Nuveen Barclays Municipal Bond ETF (TFI), the Vanguard Tax-Exempt Bond Index Fund ETF (VTEB), the VanEck Vectors AMT-Free Intermediate Municipal Index ETF (ITM), the iShares California Muni Bond ETF (CMF) and the iShares National Muni Bond ETF (MUB) demonstrated the lowest correlations with SPY, suggesting that many investors made the decision to accept less than the "max income" to also pursue better portfolio diversification.

Safety

Of course, there are also occasions when investors want a higher-than-zero return, but need to maintain minimal risk to their principal. The iShares Short-Term National Muni Bond ETF (SUB) has a short duration, has had a reasonable dividend yield as well as positive total returns. As a diversifier, however, it is ranked in the bottom half of the field. Investors who hold SUB as a lower-risk, short-to-intermediate-term investment and who also want to balance their equity risk may wish to complement the position with another muni ETF with a lower equity correlation.

Honorable Mention

Several muni ETFs from outside of the top 12 are worth pointing out: The iShares New York Muni Bond ETF  (NYF), the PIMCO Intermediate Municipal Bond Active ETF (MUNI), the SPDR Nuveen Barclays California Municipal Bond ETF (CXA), the First Trust Managed Municipal ETF (FMB) and the VanEck Vectors AMT-Free Long Municipal Index ETF (MLN) have lower correlations than most with attractive dividend yields.

In addition, the VanEck Vectors CEF Municipal Income ETF (XMPT) has been able to generate higher dividend yields and impressive total returns, but keep in mind that the leveraged closed-end muni bond funds in which XMPT invests have very long durations, so XMPT will show a very high sensitivity to changes in interest rates; hence, the strong recent performance given the current rate environment.

Looking Ahead

It is generally imprudent to try to time interest rates. The best course of action is to understand your specific goals and select the muni ETFs that best fit your goals. Read How to Pick the Right Muni ETF to better understand how to use duration and credit quality when selecting a muni ETF.

When fitting a muni ETF into your portfolio strategy, also consider how well it can be expected to diversify your existing holdings. The more your fixed-income ETF is correlated to your equity risk exposure, the larger your allocation to bonds will need to be to achieve the desired diversification.

Below is a graph of the universe of muni ETFs compared to the benchmark triple-A yield curve, provided courtesy of Municipal Market Analytics.

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.

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.