Finding Value In Municipal Bond ETFs

Although the Federal Reserve raised interest rates for the first time in almost decade last month and plenty of pundits believe multiple rate hikes are on the way this year, some investors are finding comfort in municipal bond exchange-traded funds.

The question savvy investors need to be considering right now is whether municipal bonds are inexpensive relative to other fixed income asset classes. That query can be answered by evaluating the tax-free yield to U.S. Treasury yield ratio.

Tax-Free Yield To U.S. Treasury Yield Ratio

“Are U.S. municipal bonds rich or cheap relative to other fixed income asset classes? It is all relative. As of January 15th 2016, the yield to worst of investment grade bonds tracked in the S&P National AMT-Free Municipal Bond Index was a 1.8 percent (tax-free yield). The Taxable Equivalent Yield (TEY) of those bonds using a 35 percent tax-rate assumption would be 2.77 percent (the required yield of a taxable bond to keep the same interest income after taxes),” said S&P Dow Jones Indices Managing Director and Global Head of Fixed Income J.R. Rieger in a recent note.

Related Link: MacKay Municipal Managers Announces Top Five Municipal Market Insights For 2016

Large Municipal Bond ETFs

Investors can gain exposure to the S&P National AMT-Free Municipal Bond Index with the iShares S&P Natnl AMT - Free Munpl Bd Fd MUB, one of the largest municipal bond ETFs. The $6 billion MUB has an effective duration of 4.74 years and 78 percent of the ETF's nearly 2,900 holdings are rated either AA or AAA, according to iShares data.

“By most measures, the yields of municipal bonds remain higher than the historical trend. For example, the investment grade non-callable municipal bonds maturing in 2024 tracked in the S&P AMT-Free Municipal Series 2024 Index ended at a yield of 1.87 percent verses the yield of the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index yield of 2.03 percent...or 92 percent of the U.S. Treasury yield,” added Rieger.

However, Rieger also noted that compared to investment-grade corporates, tax-free munis currently appear richly valued. That could be a sign that investors looking for a “good deal” with fixed income ETFs without sacrificing credit quality might be better off with a fund such as the iShares iBoxx $ Invest Grade Corp Bd Fd LQD than MUB.

However, LQD's effective duration is almost eight years, but its 30-day SEC yield of 3.34 percent is well above the 1.53 percent found on MUB. Investors have added $55.4 million to MUB this year compared to inflows of over $252 million for LQD.