Even if interest rates rise and pressure the fixed-income markets, municipal debt and related exchange traded funds may still find support from foreign buyers seeking higher relative yields in the U.S.
“Higher yields, very low historical default rates, and the asset class’s diversification benefits (-0.10% correlation to U.S. stocks) have all combined to create a nearly ‘perfect storm’ of foreign interest in munis, the effects of which are being felt within the municipal bond market,” Michael Cohick, Product Manager of ETFs at VanEck, said in a research note.
Foreign holdings of U.S. state and local government debt increased 16% in the last quarter of 2016 to a record level o $106.4 billion.
While foreign demand only makes a small portion of the overall $3.8 trillion U.S. munis market, international investors are becoming a growing influencing in the market. Cohick pointed out that foreign ownership of muni bonds jumped 32% over the past two years from $80.6 billion at the end of 2014 to its current $106.4 billion.
“Although the tax-free coupon is a key advantage of investing in municipal bonds, it is only available to U.S. investors,” Cohick said. “Foreign buyers have not been deterred, and continue to pour into the American muni bond market in search of higher yields from perceived low risk infrastructure investments. The attractive yields of U.S. municipal bonds are proving to be attractive to yield-starved foreign investors who struggle to find comparable yields at home.
For example, yields on benchmark 10-year German bunds is 0.43%. Yields on benchmark 10-year Japanese Government Bonds is 0.05%. In contrast, the widely observed S&P National AMT-Free Municipal Bond Index shows a yield to worst of 2.25% and a yield to maturity of 3.05%.
Along with their attractive yields, munis are also perceived as low risk investments with low default risks. According to Moody’s Investors Service, the 1970 through 2015 average cumulative 10-year default rate for all rated munis was only a minuscule 0.15%. In contrast, all rated global corporate bonds averaged a 10.16% 10-year default rate over the same period.
“Muni bonds are also attractive to foreign investors for another reason: they are perceived as safe havens, being thought similar to U.S. Treasuries, with near-zero default rates,” Cohick said. “We believe the safe haven reputation is well deserved.”
ETF investors can also capitalize on the growing support from foreign demand through a number of munis-related ETF options.
For example, the VanEck Vectors CEF Municipal Income ETF (NYSEArca: XMPT), which tries to reflect the performance of the S-Network Municipal Bond Closed-End Fund Index, comes with an attractive 5.15% 30-day SEC yield or an 8.52% taxable equivalent 30-day SEC yield for those in the highest income bracket. Moreover, XMPT provides distributions on a monthly basis for those income-oriented investors.
Unlike other muni bonds, XMPT tracks shares of municipal closed-end funds. Closed-end funds, or CEFs, are publicly traded investment companies that raise a fixed amount of capital through an initial public offering, and the fund is then structured, listed and traded like a stock on an exchange.
The VanEck Vectors High Yield Municipal Index ETF (NYSEArca: HYD) is also another high-yield muni option, with a 4.44% 30-day SEC yield or a 7.34% taxable equivalent 30-day SEC yield for those in the highest income bracket. HYD has also been a popular foreign play, with 6.5% of the fund’s assets coming from abroad and nearly $100 million from Taiwan where yields on 10-year government bonds hover around 1.1%.
For a more traditional muni play, the VanEck Vectors AMT-Free Intermediate Municipal Index ETF (NYSEArca: ITM) tracks intermediate duration investment-grade munis with an effective duration of 7.12 years. ITM comes with a 2.47% 30-day SEC yield, or a taxable equivalent 4.09% yield.
A long-term muni fund like the VanEck Vectors AMT-Free Long Municipal Index ETF (NYSEArca: MLN) comes with a more attractive 3.27% 30-day SEC yield or a taxable equivalent 5.41% yield, but it is exposed to greater interest rate risk, with an effective duration of 11.31 years.