ETF Trends
ETF Trends

The municipal bond market and related exchange traded funds will continue to benefit from the supply-demand but investors could see short-term volatility from default speculation, notably in Puerto Rican debt.

“I think the tailwinds are still very positive for municipal bonds,” Jim Colby, portfolio manager for Market Vectors’s suite of municipal bond ETFs, said on Van Eck Global.

Specifically, Colby points to the ongoing divergence between demand and supply as investors, notably those in the higher income brackets, enjoy the tax-exempt perks of holding municipal debt while states are reluctant to increase their balance sheets. [Muni Nation: The Best Defense is a Good Offense]

For example, the iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB) comes with a 1.58% 30-day SEC yield or a 2.79% taxable equivalent 30-day SEC yield for those in the highest income bracket, and the Market Vectors Intermediate Municipal Index ETF (NYSEArca: ITM) has a 2.05% 30-day SEC yield and a 3.40% taxable equivalent 30-day SEC yield for those in the highest income bracket. [Muni Bond ETFs: Considerations & Factors to Watch]

“There has been one theme, one overriding theme, that has driven performance right from the very get-go of 2014, and that has been a supply-demand imbalance,” Colby said. “By that, I mean the demand for municipal bonds, fundamentally created by coupon, maturities and bond call investment, has completely overwhelmed the supply of new issuance in the municipal bonds marketplace.”

Colby also anticipates that the supply imbalance will run through the rest of the year and even into the first quarter of 2015

In the fixed-income space, interest rate risk is the largest single concern. MUB has a 6.42 year effective duration and ITM has a 6.76 year duration. Consequently, a 1% increase in interest rates would translate to about a 6.4% decline in MUB and a 6.8% decline in ITM. However, Colby points out that the Federal Reserve won’t likely change its rate stance anytime soon, so bond investors can expect rates to remain low for the foreseeable future.

Credit risk, though, may be a more short-term concern. Investors could see short-term shocks from downgrades to muni debt, such as what happened with Puerto Rico. Puerto Rico headlines could continue to drive swings as the island is the third largest issuer of muni debt.

Investment-grade muni bond ETFs, like MUB and ITM, do not include the speculative-grade quality Puerto Rican debt. However, high-yield muni funds, like the Market Vectors High Yield Municipal Index ETF (NYSEArca: HYD), include some Puerto Rico exposure. HYD has a 3.8% tilt toward Puerto Rico. The ETF has a 4.67% 30-day SEC yield, or a 7.74% taxable equivalent yield for those in the highest income bracket, and a 10.25 year duration.

For more information on the munis market, visit our municipal bonds category.

Max Chen contributed to this article.

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.