Earlier this week, Moody’s Investors Service lowered Chicago’s credit rating to junk status after the Illinois Supreme Court ruled against a state pension reform plan. Moody’s says Chicago’s public pension plan is underfunded by $20 billion, but some high-yield municipal bond exchange traded funds have remained durable in the face of the Chicago controversy.
For example, the Market Vectors High Yield Municipal Index ETF (NYSEArca: HYD) is little changed this week. The $1.6 billion ETF holds 1,003 municipal issues and allocates 4.5% of its weight to Illinois bonds, tying the state with Pennsylvania as the ETF”s seventh-largest state exposure, according to Market Vectors data.
Moody’s downgrade of Chicago’s credit rating has been criticized by Mayor Rahm Emanuel and some municipal bond traders are vexed because Standard & Poor’s rates Chicago A+, the fifth-highest rank, on Chicago debt.
“What’s behind Moody’s downgrade of Chicago? Part of this downgrade is an attempt by Moody’s to be aggressive with “stressed” credits, as opposed to their being behind the yield curve in the years leading up to the calamities,” said Jim Colby, chief municipal strategist at Van Eck Global, in a note out Thursday. “What are the implications for the municipal bond market? Although $8.1 billion is a significant capitalization, it represents less than one-half of 1% of all outstanding municipals (some $3.7 trillion). The market takes notice of this news, but doesn’t shudder in response.”
In addition to HYD, other muni bond ETFs have taken news of Chicago’s junk rating in stride. For example, the Market Vectors Intermediate Municipal Index ETF (NYSEArca: ITM) is down just a third of a percent this week even with its 4.2% weight to Illinois bonds. [A Boost for Muni Bond ETFs]
With muni ETFs, investors can also spread out risk with various state exposure. The three muni ETFs are market-cap weighted, so the states with the largest outstanding debt have the biggest weights, which include California, New York and Texas, respectively.
The $1.1 billion ITM has a 30-day SECE yield of 2.16% and an effective duration of 7.35 years. HYD has a 30-day SEC yield of 4.43% and an effective duration of 10 years. [Diversify With Cheap Muni ETFs]
In the wake of the Chicago new, Colby points out there are other major U.S. cities facing significant short falls in public pensions, including Philadelphia, Memphis, Jacksonville, Phoenix and Little Rock. Florida, Pennsylvania and Arizona combine for 13.3% of HYD’s weight.
“Where should municipal investors turn? Generally, we continue to advocate municipals because in the context of a highly diversified portfolio the credit quality is strong and the yields are the equivalent of – if not higher than- US Treasuries. For those who can manage a little credit risk, the municipal high yield market is especially attractive, with nominal yields higher than those of the U.S. Corporate high yield market, with lower overall default experience,” adds Colby.
Market Vectors High Yield Municipal Index ETF
Tom Lydon’s clients own shares of HYD.