In the first quarter 2015, investors put $1.4 billion of fresh money into municipal bond ETFs compared to $1.9 billion during all of 2014. Meanwhile, $9 billion went into municipal bond mutual funds this year.
According J.R. Rieger, Global Head of Fixed Income at S&P Dow Jones Indices, with no tax-relief in sight, demand for tax-exempt municipal bonds has outpaced supply helping to drive prices higher. Meanwhile he notes that the investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index have stronger credit quality than their corporate counterparts.
Indeed, iShares National AMT-Free Muni Bond (MUB), which tracks the aforementioned S&P index, recently had 99% of its bonds rated A or higher by rating agencies that operate independently from S&P Capital IQ and S&P Dow Jones Indices. Meanwhile, iShares iBoxx Investment Grade Corporate Bond ETF (LQD) had 65% of its bonds rated A or higher.
In contrast, Fidelity Intermediate Municipal Income Fund (FLTMX), an actively managed mutual fund, had 90% invested in bonds rated A.
Relative to individual bonds, investors in municipal bond ETFs and mutual funds benefit from diversification. There are approximately 2,600 bonds inside MUB, while FLTMX holds 1,000. However, the bonds are issued by various states, limiting the local tax benefits.
At first glance, the 1.6% 30-day SEC yield for MUB appears quite low relative to LQD’s 3.0%, we think a fair comparison would involve an adjustment to reflect the tax benefits. On a tax-equivalent basis using a 35% tax rate, investors in MUB would receive a 2.4% yield.
Furthermore,as the Federal Reserve is expected to raise interest rates in 2015 as the U.S. economy strengthens, investors need to be mindful of a bond portfolio’s average duration. Duration is a measure of the impact on a portfolio when rates rise by 100 basis points. MUB’s duration at 6.3 years is nearly two years lower than LQD, meaning it will decline 200 basis points less than the corporate bond ETF if rates climbed;. FLTMX’s duration is even lower at 4.8 years.
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