ETF Trends
ETF Trends

Municipal bond exchange traded funds, once a favored destination for conservative, income-seeking investors, have come under pressure this year.

Rising interest rates, which have adversely affected muni ETFs, are only part of the reason. The specter of massively under-funded public pension liabilities across, highlighted by Detroit’s bankruptcy, has made some investors skittish about an asset class previously viewed as docile. [Detroit Bankruptcy Casts Shadow Over Muni ETFs]

Earlier this month, Federal Bankruptcy Judge Steven Rhodes, to the surprise of lawyers and muni market observers, said Detroit’s public pensions are not protected in the city’s bankruptcy. Michigan is not alone when it comes to public pension problems. “Indeed, according to a recent report prepared by State Budget Solutions (SBS), a non-profit public policy organization, the funding gap in public employee pension plans (or the difference between the pension obligations and the amount states have set aside for those obligations) is a staggering $4.1 trillion,” S&P Capital IQ points out in a new research note.

Combining unfunded liabilities with unfunded liabilities as a percentage of state GDP shows nine states, including well-populated states, such as Illinois, Ohio and New Jersey, are atop both lists, S&P Capital IQ notes. And that does not include the $329 billion California’s public pension system is reportedly under-funded by.

“Those state and local governments that are successful at taming the upward spiral of pension liabilities may see their efforts rewarded in the form of a healthier fiscal balance sheet. Investors have already started to respond favorably, lifting prices for the bonds of many of these issuers. Although we believe the rising tide of pension reform may lift a number of entities, we think investors would be wise to diversify among holdings in this space. One effective way to achieve this is through the use of ETFs,” said S&P Capital IQ in the note.

S&P Capital IQ has overweight ratings on the iShares National AMT-Free Muni Bond ETF(NYSEArca: MUB) and the SPDR Nuveen Barclays Municipal Bond ETF (NYSEArca: TFI), which are down an average of 3.5% this year. [Muni Bond ETFs See Outflows]

MUB is not light on states with pension risk. Munis issue by California, New York, Illinois and New Jersey combine for about 52% of the fund’s weight.

High-yield muni bond ETFs have been hit this year by rising rates, though it is worth noting that all of the ETFs mentioned in this piece have traded higher over the past 90 days, a time frame that has seen the Detroit pension controversy escalate.

S&P Capital IQ has marketweight ratings on the Market Vectors High Yield Municipal Index ETF (NYSEArca: HYD) and the SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEArca: HYMB). California, Illinois and New Jersey combine for over 29% of HYMB’s weight.

iShares National AMT-Free Muni Bond ETF

ETF Trends editorial team contributed to this post. Tom Lydon’s clients own shares of HYD.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.