Municipal bonds and related exchange traded funds have been one of the best performing assets in the fixed-income space as attractive yields and shortage in supply bolster prices. However, munis could begin to cool if interest rates rise later this year.
Muni ETFs have bee outperforming Treasury funds with similar duration exposure. For instance, the iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB) gained 3.3% year-to-date, compared to the 2.7% rise in the iShares 7-10 Year Treasury Bond ETF (NYSEArca: IEF).
According to Bank of America Merrill Lynch data, municipal bonds have returned 3.4% this year after falling 2.9% over 2013, the first decline since 2008. [Muni Nation: Waiting to Exhale]
Investors are attracted to the higher tax-free equivalent yields found in municipal bonds. MUB has a tax equivalent 30-day SEC yield of 3.85% for those in the highest income bracket, whereas IEF comes with a 2.38% 30-day SEC yield.
Additionally, Peter Hayes of BlackRock Strategic Municipal Opportunities Fund points out that investors can get up to 3 percentage points extra if they are willing to hold riskier high-yield munis, and even more for distressed Detroit and Puerto Rico plays, reports Lewis Braham for Reuters.
For example, the popular Market Vectors High Yield Municipal Index ETF (NYSEArca: HYD) has a tax equivalent 30-day SEC yield of 9.48% for those in the highest income bracket. Puerto Rico makes up 6.7% and Michigan is 2.1% of the ETF’s overall portfolio. [Muni Bonds: Puerto Rico Readies $3 Billion in Junk Debt]
However, Morgan Stanley analysts led by Michael Zezas warns that the $3.7 trillion munis market is set to “cool off” over the next three months due to rising interest rates, reports Romy Varghese for Bloomberg.
Morgan Stanley predicts benchmark yields on 10-year Treasuries will hit 3.3% in the fourth quarter as the economy improves. Consequently, Zezas warns that munis can experience a 1% loss over the next three quarters.
“As the economy transitions to a higher growth channel, we expect some more pain from rising rates before valuations become attractive,” Zezas added.
iShares National AMT-Free Muni Bond ETF
For more information on the munis market, visit our municipal bonds category.
Max Chen contributed to this article.