Muni Investors Haven’t Been Waiting On Fed

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.

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.

Side Note