Active Vs. Passive through Muni Bond Investing

Municipal bond mutual funds gathered $2.8 billion in the four-week period ended October 28, according to Investment Company Institute, even as muni bond ETFs added $593 million of inflows in October. However, at a recent S&P Dow Jones Indices Municipal and Global Bond Forum, various panelists highlighted the relative benefits of municipal bond ETFs.

J.R. Rieger, Managing Director of Fixed Income Indices for S&P Dow Jones Indices, highlighted that just one-third of all active national municipal bond funds outperformed the S&P Municipal Bond index in the three-year period ended June 2015. Further, just 16% of those funds that were in the top-quartile of their muni bond peer group in the 12-month period ended March 2013 retained that ranking in the subsequent period.

For investors seeking to replicate the aforementioned S&P investment-grade bond index, there are two choices. iShares National AMT-Free Municipal Bond (MUB) is the larger and older of the two, with $5.6 billion in assets. The ETF has a 0.25% expense ratio and trades approximately 300,000 shares on a daily basis.

A fellow panelist at the S&P Dow Jones forum, Stephen Winterstein, Managing Director of Research & Chief Strategist for Wilmington Trust Investment Advisors, acknowledged one advantage index-based ETFs have over active mutual funds is explicit parameters that are not subject to a manager's view of the world. We think a look at two popular New York municipal bond products makes this point clear.

iShares New York AMT-Free Muni Bond ETF (NYF), a $180 million ETF, tracks a broad, market value-weighted S&P index that seeks to measure the performance of bonds issued within New York. All the bonds inside NYF have investment-grade credit ratings. However, if you live in New York, the ETF's 1.7% 30-day SEC might look low relative to the Lipper New York Municipal Debt fund mutual fund peer group's 2.1%.

However, the mutual fund universe is impacted by those funds that also invest in bonds issued outside of New York that have higher yields. For example, Oppenheimer Rochester AMT-Free New York Municipals (OPNYX), has an elevated 4.5% yield. Unlike NYF, OPNYX has a 20% stake in Puerto Rico bonds that we think incur greater credit risk, in exchange for a higher yield.

Bonds issued by Puerto Rico bonds are exempt from federal, state and local income taxes for individual investors. In September 2015, Standard & Poor's Ratings downgraded Puerto Rico-backed debt to CC, citing that the bonds are highly vulnerable to nonpayment.

A separate difference between municipal bond ETFs and mutual funds is that ETFs trade on an exchange, allowing investors the liquidity to make trades intra-day. Yet at the same S&P Dow Jones forum, Mariana Bush, Senior ETF Analyst for Wells Fargo, reminded attendees that municipal bond ETFs net asset values (NAVs) are a best estimate. Bush explained that unlike Treasury bonds it is rare for muni bonds to trade on a daily basis. As such, according to our research, muni ETFs that hold these securities can at times trade at relatively wider premiums or discounts to NAVs.

S&P Capital IQ has research on 33 municipal bond ETFs, 22 of which have price/NAV premiums or discounts greater than 10 basis points. Meanwhile, just 2 of the 22 US Treasury ETFs trade as widely relative to its net asset value.

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