Spotlight on US municipal bond ETFs

May 31st, 2016 | By | Category: Fixed Income

The US municipal bond market is by far the largest of its kind throughout the world; statistics from US trade group SIFMA put its value at $3.7tn. The amount also represents a significant increase from $1.9tn in 2003. As the market has grown, so has the number of exchange-traded funds offering a variety of maturity exposures to the sector.

Spotlight on US municipal bond ETFs

The US municipal market is the largest in the world with total assets of over $3.7tn. ETF providers such as iShares, State Street Global Advisors, Van Eck Global and PowerShares all have funds with over $1bn in AUM covering the space.

Municipal bonds are debt securities issued by a state, municipality or county to finance its capital expenditures. They are exempt from federal taxes and from most state and local taxes. Municipal bonds fall within two general categories: general obligation bonds (those that are secured by the authority’s pledge to use tax revenues to repay bond holders) and revenue bonds (those that rely on income generated from a specific project into which the funds were allocated to repay bond holders).

Due to the inherent link between taxes raised and ability to pay, the state of the broad US economy should play an important role in investors’ analysis of municipal bond funds. The US economy continues to exhibit relatively attractive growth (the economy grew by annualised rates of 2.0% and 1.4% in Q4 2015 and Q1 2016 respectively, according to data provider Trading Economics) while inflation remains within the Federal Reserve’s target limits (the most recent inflation estimate was 1.1%, published by the US government on 17 May 2016 and covering the 12 months ended April 2016). Ratings agency Fitch recently issued stable forecasts across all 50 US states, the first time this has been achieved since before the 2008 financial crisis.

Certain states are still managing their share of problems, including reduced revenues due to low energy prices in oil producing states such as Alaska, Texas and Oklahoma, as well as pressures from unfunded pension fund statuses in Chicago and Illinois. In this way, broad reaching ETFs that diversify away the idiosyncratic risk attributable to any one state may be preferable to risk-wary investors.

Demand is expected to be robust during 2016, fuelled by the momentum of the industry’s outperformance last year. The majority of the municipal bond market is owned by retail investors who are historically more likely to boost net inflows into an asset type following periods of strong performance. Indeed, municipal bonds were the strongest performing asset type during 2015 with investment grade municipal bonds returning 3.3% (5.8% on a tax-adjusted basis) and high yield municipal bonds, excluding Puerto Rico, delivering 7.5% (13.3% on a tax-adjusted basis). There were positive net inflows into the sector of $15.8bn over the course of the year.

Demand is also expected to increase due to an increasing need for tax-favoured investments. Recent changes to US tax laws has seen the top marginal rate of tax be increased from 35% to 39.6%, the tax on long-term capital gains and dividends rise from 15% to 20%, and a new 3.8% tax on investment income (from which municipal bonds are exempt). These changes are expected to motivate investors to shift a greater proportion of assets into tax-advantaged municipal bond markets.

On the supply side, the amount of new issuances has dipped slightly since the end of the Build America Bond Program which expired on 31 December 2010. Refinancing remains strong though and has resulted in relatively stable levels of total bond issuances over the last five years. As such, going forward it is expected that both the supply and demand side of the market will be robust with potentially more pressure being exerted from buyers.

Spreads on municipal bonds do remain tight though; as of 20 May 2016 the spread of 10-year AAA-rated municipal bonds over similar duration Treasuries was just 0.21% after accounting for the tax advantages of municipal bonds. As such there remains very little room for outsized gains and with rates remaining near all-time lows, interest rate risk may play a factor should the Federal Reserve be pushed into frequent rate increases. That being said, municipal bond prices have historically fallen by roughly half the extent of Treasuries during times of rate increases. As such, municipal bonds may provide a relative degree of insulation for investors concerned over interest rate risk.

Investors should also be aware that municipal bonds have historically produced better default rates compared to other fixed income securities with similar credit ratings. For example, from 1986 – 2015, 0.74% of US-listed AAA-rated corporate debt instruments defaulted; over the same period there were no defaults within AAA-rated municipal debt. Municipal bonds rated AA experienced a 0.03% default rate during the period compared to 0.82% for similar rated corporate bonds. A-rated municipal debt had a 0.09% default rate compared to 1.51% for A-rated corporate bonds.

In summary, the continued slow and steady economic recovery within the US bodes well for the repayment of both general obligation and revenue municipal bonds through greater tax receipts as well strong economic activity respectively. The market is expected to be supported from strong demand pressures from a technical perspective but with spreads already tight there is little room for large active returns. Instead, the attractive risk/return characteristics of municipal bonds may present an attractive opportunity for fixed income investors looking to increase income by capturing coupons. If the yield curve does flatten in the short to medium term this may boost returns to investors.

That being said, if inflation does begin to run higher and the Federal Reserve is forced to speed up the pace of interest rate increases, this may cause significant losses to the portfolio.

Investors wishing to gain access to the US municipal bond market through ETFs may wish to consider the:

iShares National Muni Bond ETF (MUB)
With over $6.8bn in assets under management this fund is the largest ETF to track the US municipal bond market. The ETF has over 3,000 holdings, thereby offering a diversified investment. As of 19 May 2016 the 30-day SEC yield is 1.31%%. The effective duration is 4.71 years. State Tax-Backed Bonds (38.4%) make up the largest sector, followed by Utility (15.4%), Transportation (15.0%), and Local Tax-Backed Bonds (11.3%). The fund adopts a barbell portfolio with significant holdings in the ranges of 0-3 years (20.0%), 3-6 years (12.4%), 15-20 years (12.3%), 20-25 years (13.7%) and 25+ years (14.1%). The credit quality with the largest weight is AA (56.0%), followed by AAA (22.8%) and A (18.5%). The major geographic exposures are to California (23.0%), New York (19.9%), Texas (9.1%) and Massachusetts (4.7%). The total expense ratio (TER) is 0.25%.

SPDR Nuveen Barclays Short Term Municipal Bond ETF (SHM)
As of 20 May 2016, the ETF invests its $2.8bn in AUM primarily in municipal bonds with maturities of 3-5 years (52.5%), 2-3 years (24.9%) and 1-2 years (20.5%). There are over 700 holdings in the fund and the 30-day SEC yield on the fund is 0.68%. The duration of the fund is 2.82 years. General Obligation Bonds make up the majority of the fund’s holdings with GO State (30.3%) and GO Local (23.8%) holding the largest weights. Special Tax (14.6%), Transportation (8.6%) and Power (6.9%) also play significant roles. The credit quality with the largest weight is AA (75.5%) followed by AAA (23.6%). The major geographic exposures are to California (19.0%), New York (16.3%), Texas (9.1%) and Maryland (5.3%). TER – 0.20%.

SPDR Nuveen Barclays Municipal Bond ETF (TFI)
As of 20 May 2016, the ETF invests its $1.8bn in AUM primarily in municipal bonds with maturities of 10-15 years (20.3%), 20-30 years (20.3%), 15-20 years (15.2%) and 5-7 years (12.3%). There are over 880 holdings in the fund and the 30-day SEC yield on the fund is 1.53%. The duration of the fund is 6.85 years. General Obligation Bonds make up the majority of the fund’s holdings with GO State (24.8%) and GO Local (21.3%) holding the largest weights. Water & Sewer (14.4%), Special Tax (11.6%) and Education (9.8%) bonds also play significant roles. The credit quality with the largest weight is AA (78.7%) followed by AAA (21.2%). The major geographic exposures are to California (19.5%), New York (18.7%), Texas (11.3%) and Washington (4.9%). TER – 0.23%.

VanEck Vectors AMT-Free Intermediate Municipal Index ETF (ITM)
As of 20 May 2016, the ETF invests its $1.4bn in AUM primarily in municipal bonds with maturities of 10-15 years (51.9%), 7-10 years (33.5%), and 5-7 years (8.2%). There are over 1,600 holdings in the fund and the 30-day SEC yield is 1.61%. The duration of the fund is 6.60 years. General Obligation Bonds make up the majority of the fund’s holdings with GO State (25.7%) and GO Local (19.0%) holding the largest weights. Transportation (12.0%), Special Tax (10.1%) and Water & Sewer (8.5%) bonds also play significant roles. The credit quality with the largest weight is AA (60.0%) followed by A (21.1%) and AAA (15.2%). The major geographic exposures are to New York (16.4%), California (15.5%), Texas (10.3%) and Florida (5.0%). TER – 0.24%.

PowerShares National AMT-Free Municipal Bond Portfolio ETF (PZA)
As of 20 May 2016, the ETF invests its $1.2bn in AUM primarily in municipal bonds with maturities of 20-25 years (40.3%), 25+ years (33.5%), and 15-20 years (18.4%). There are over 300 holdings in the fund and the 30-day SEC yield is 1.76%. The duration of the fund is 6.30 years. The credit quality with the largest weight is A (45.0%) followed by AA (42.0%) and AAA (3.0%). TER – 0.28%.

iShares Short-Term National Muni Bond ETF (SUB)
As of 20 May 2016, the ETF invests its $1.0bn in AUM primarily in municipal bonds with maturities of 0-3 years (70.7%), and 3-6 years (29.0%). There are over 780 holdings in the fund and the 30-day SEC yield is 0.54%. The duration of the fund is 1.92 years. General Obligation Bonds make up the majority of the fund’s holdings with GO State (43.6%) holding the largest weight. Prerefund (20.4%), Utility (11.2%) and Transportation (9.8%) bonds also play significant roles. The credit quality with the largest weight is AA (51.3%) followed by AAA (35.7%) and A (11.9%). The major geographic exposures are to California (19.9%), New York (15.1%), Texas (7.5%) and Massachusetts (6.4%). TER – 0.25%.

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