Municipal Bond ETFs Ignore Rising Rate Concerns

The investment community is holding its breath this week as the Federal Reserve meets to decide the fate of interest rates. Expectations are now centered on a small quarter point increase in the federal funds rate, which has the potential to jolt both the stock and bond markets. Many sectors tied to interest rate or credit sensitivity have seen a recent uptick in volatility in anticipation of this event.

In spite of those concerns, one arena that has continued on a steady upward trend has been municipal bond funds. These tax-conscious vehicles have been rock solid during a relatively choppy interest rate environment and now stand as the top fixed-income sector in 2015.

The largest exchange-traded fund in this category is the iShares National AMT-Free Muni Bond ETF (MUB), which has over $5.7 billion in total assets. This index is made up of a diverse array of 2,900 municipal debt securities spread around the country and charges an expense ratio of just 0.25%.

MUB has a 30-day SEC yield of 1.66% and dividends are paid monthly to shareholders. Investors in the top tax brackets favor municipal bond funds such as MUB for the federally tax-free income that they provide. This can be a big advantage for reducing the impact of a sizeable tax burden on non-retirement accounts for those that need the stability and low volatility of fixed-income.

This ETF has managed to generate a total return (with dividends) of 2.38% so far in 2015. That is significantly better than the 0.45% gain in the iShares Barclays U.S. Aggregate Bond ETF (AGG) over the same period. This meaningful divergence has been the result of strong demand in the municipal sector versus weakness in corporates and treasuries over the last two months.

This trend has not gone unnoticed by income investors either. On a year-to-date basis, MUB has added $1.6 billion in new inflows as a consistent trend of strength prevails. This steady stream of fresh investor capital, with little net selling, has likely been a driver of outperformance in the fourth quarter versus other fixed-income options.

For those with a more conservative nature or looking to insulate themselves from interest rate risk, the SPDR Nuveen Barclays Short Term Municipal Bond (SHM) is another top option. SHM has $2.7 billion dedicated to a national index of nearly 600 quality municipal bonds. The average maturity of the bonds in this ETF is just 3.09 years compared to 5.48 years in MUB. The tradeoff is that SHM comes with a far lower yield of just 0.84% along with compact volatility in the daily price fluctuations of the fund.

On the flip side, the top performing municipal ETF this year has a much more aggressive slant. The Market Vectors CEF Municipal Income ETF (XMPT) has jumped over 5% in 2015 as its underlying portfolio of 84 tax-free closed-end funds rocketed higher. This “fund of funds” strategy is designed to capitalize on the unique characteristics that closed-end funds have to offer such as active management and the use of leverage.

XMPT has a 30-day SEC yield of 5.45% and income is paid monthly. According to the Market Vectors website, that translates into a taxable equivalent yield of 9.02% for tax payers in the top 39.6% federal tax bracket. Of course, that higher yield comes with a much greater risk to price volatility for principal invested.

The Bottom Line

The recent trend in municipal bond leadership shows a sense of conviction by investors that the Fed ultimately will not raise rates or a comfort with the risk of their tax-focused investments. The ETFs mentioned above can be beneficial for those who are seeking tax-advantaged income from a diversified pool of national entities.

Nevertheless, keep in mind that these funds often come under fire during recessionary periods as state and local governments see revenues fall. They are also susceptible to a sustained period of inflationary pressures and cyclical interest rate fluctuations.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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