How Higher Rates Could Actually Help Muni Bond ETFs

The widely followed ICE AMT-Free US National Municipal Index is higher by 1.17% year-to-date, indicating 20-year high interest rates aren’t sapping muni bonds as they did last year.

It’s not clear that the Federal Reserve is done tightening this year. Even murkier is the 2024 timeline regarding when rate cuts will arrive, if at all. However, 2023 sturdiness in municipal debt could be a signal that investors can wade back into the higher-yield portion of the pool and evaluate exchange traded funds such as the VanEck High Yield Muni ETF (HYD).

HYD, which tracks the ICE Broad High Yield Crossover Municipal Index, is sporting  a modest year-to-date gain, but investors are well-compensated for embracing the ETF as highlighted by a 4.68% 30-day SEC yield – high by the standards of muni bond funds. Additionally, HYD could find other tailwinds as 2023 draws to a close.

HYD Could Derive High Rate Benefits

Conventional wisdom holds that when interest rates rise, bond prices and those of the related ETFs decline. That was the case last year and HYD tumbled as a result. Specific to munis and HYD, a benefit attributable to interest rates is emerging.

With rates at two-decade highs, bond issuers – regardless of fixed income segment – are forced to attach higher yields to new issues than they were two or three of five years ago. That means higher interest expenses. As such, some state and local issuers are holding back on bringing new municipal debt to market. In fact, as of mid-August, the year-to-date pace of municipal bond issuance was the slowest since 2019.

“The scarcity is fueling outperformance in the asset class. Municipal bonds returned 0.4% in July, better than a 0.35% decline in US Treasuries, according to data compiled by Bloomberg. Month to date, munis lost 0.8%, less than Treasuries and corporates, which lost 1.2% and 1.8% respectively,” reported Bloomberg.

In other words, “scarcity sells.” Demand for muni bonds remains steady. However, with a dearth of new issues coming to market, prices of existing bonds have floors – that’s a good thing. Further supporting the case for HYD is the point that with fewer muni issues being marketed, institutional investors are reluctant to sell existing holdings. In theory, that creates an environment where there are more buyers than sellers.

That could positive for the $2.74 billion HYD, which allocates over a third of its weight to debt courtesy of California, New York and Illinois issuers.

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