Rising interest rates have been somewhat of a thorn in the side of municipal bond investors this year, but some market observers believe that overall, the asset class is on solid footing. That could bode well for exchange traded funds, including the iShares National Muni Bond ETF (NYSEArca: MUB), SPDR Nuveen Bloomberg Barclays ST Municipal Bond ETF (NYSEArca: SHM) and Vanguard Tax-Exempt Bond ETF (NYSEArca: VTEB), heading into 2019.
“Rising interest rates also contributed to the muni market’s negative returns in the past several weeks,” said Morningstar in a note out Thursday. “As investors sought insulation from those rising rates, short-term and floating-rate muni bonds became more popular, and the demand for long munis lagged. Recent tax reform also played a part here, because it disincentivized banks and insurance companies from using longer munis for tax shelter.”
Munis also help diversify fixed-income portfolios. Investors who typically follow the Barclays U.S. Aggregate Bond Index will not have municipal bond exposure, so a muni bond ETF can complement core fixed-income positions.
Interest Rate Outlook
While Federal Reserve Chair Jerome Powell indicated Wednesday U.S. interest rates are nearing “neutral,” it is still widely expected the Fed will proceed with its fourth rate hike of 2018 in December.
Over the long term, municipal bonds have historically performed well when interest rates rise.
Municipal bonds continue to experienced robust demand from U.S. investors as reliable source of yield, especially among taxable accounts due to the debt securities’ favorable tax-exempt status. The calendar indicates investors may want to give munis a look over the near term.
“There’s reason to look for a solid ending to the year for the muni market though. Historically, late November and December have been stronger months for munis because issuance lightens up and investors still hunt for yield. And while munis have generally underperformed in 2018, the fundamental credit quality of many issuers has improved,” according to Morningstar.
The strong U.S. economy is helping states and municipalities collect more tax revenue, bolstering the case for municipal bonds and the aforementioned ETFs.
“A strong U.S. economy has boosted the tax revenues of many state and local governments year to date, and that should ease some budget pressure moving forward,” said Morningstar.
For more information on the munis market, visit our municipal bonds category.