ETF Trends
ETF Trends

Speculation that the Federal Reserve is close to raising interest rates is not chasing investors from fixed income exchange traded funds.

Investors added $35.7 billion to bond ETFs in the first quarter. Municipal bond funds got in on the action. In the first quarter 2015, investors put $1.4 billion of fresh money into municipal bond ETFs compared to $1.9 billion during all of 2014, said S&P Capital IQ in a new research note. In fact, demand for munis is outstripping supply.

“Demand for tax-exempt bonds is in large part driven by the current tax environment. Demand still outpaces supply. While new issues have been increasing, the volume is partly driven by refunding bonds replacing higher yielding bond issues,” said J.R. Rieger, global head of fixed income, S&P Dow Jones Indices, in a recent note.

The iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB), the largest muni ETF, has accounted for the bulk of this year’s inflows to these ETFs with nearly $685 million in new assets added. MUB “recently had 99% of its bonds rated A or higher by rating agencies,” according to S&P Capital IQ. The research firm rates the ETF marketweight. [Muni Bond ETFs for Diversity]

Investors also have not shied away high-yield muni ETFs. For example, the Market Vectors High Yield Municipal Index ETF (NYSEArca: HYD) has added over $106 million of its $1.6 billion in assets this year. HYD has a 30-day SEC yield of 4.32%, more than double the yield on 10-year Treasurys. [Investors Flock to Muni Bond ETFs]

As Rieger notes, there are headwinds to consider with municipal bonds, including the massive public pension problems in Illinois and New Jersey. Bonds from those states combine for 9.4% of HYD’s weight.

“Each of these states has pretty large pension short falls to negotiate and this may result in headline after headline of bad press,” said Rieger.

That is to say nothing of California, where CalPERS, the largest U.S., public pension system is to blame for the Golden State’s spate of municipal bankruptcies. CalPERS confirms that “the average CalPERS pension is a modest $2,784 per month.”

That means the average CalPERS pensioner collects $33,408 per year, but that is up from $20,532 per year in 1999. As the recent municipal bankruptcy proceedings in California show, CalPERS gets paid and bondholders get the shaft, a scenario that lends risk to investors and ETFs with big California muni exposure. HYD has a 9.3% weight to California munis.

Investors looking to mitigate duration risk while maintaining a high-quality credit profile can consider ETFs such as the Market Vectors-Short Municipal ETF (NYSEArca: SMB).

Rated marketweight by S&P Capital IQ, SMB has 30-day SEC yield of 1.01% and a modified duration of 3.01 years. Investors have added $3.5 million to the $275 million fund this year. California, New Jersey and Illinois bonds combine for 27.9% of SMB’s weight.

Market Vectors-Short Municipal ETF