Muni Catchup 9/19
by Pat Luby
Individual Ownership of Munis is Growing
New data from the Federal Reserve show that individual ownership of municipal bonds grew in the second quarter this year–but what is interesting is that the growth has been in professionally managed munis. While direct ownership of individual munis declined by $15 billion in Q2, it was offset by increases in ownership of muni mutual funds ($40 billion), closed-end funds ($2.5 billion) and ETFs ($2.1 billion).
Muni ownership even increased among non-U.S. buyers and non-muni bond mutual funds. See the Muni Catchup 9/16 for additional insight about the holders data.
Muni ETFs are Growing
With all of the challenges in the market and economic environments, it is not surprising that individual investors are putting more money into professionally managed solutions, both active and passive. Even with the recent market volatility, money has continued to flow into muni bond mutual funds and muni ETFs. (See the Context page for the weekly update.)
While ETFs represent only about 4% of the muni fund assets, they have been attracting about 10% of the net new asset flow. That out-sized share of asset flows helps explain why Van Eck will be launching two new muni ETFs this week:
- AMT-Free 6-8 Year Municipal Index ETF (ITMS). Estimated Duration 5.80
- AMT-Free 12-17 Year Municipal Index ETF (ITML). Estimated Duration 7.30
As a point of reference, based on current benchmark rates and assuming new purchases of all par bonds, a hypothetical 10-year laddered high-grade (double or triple “A” rated) portfolio right now would have an average weighted duration of 5.19 with an average yield to maturity of 1.23%
Risks are Growing
In “A Sour Surprise for Public Pensions,” The New York Times provides an excellent illustration of the financial challenges facing many public pension funds. This is an issue that is growing in awareness, and the longer that low rates depress pension fund portfolio earnings, the dollar size of the issue will grow as well. It is likely that the magnitude of some of the numbers involved will be affecting municipal credit ratings and market liquidity. In case you missed it, I encourage you to also read Pensions & Transparency in the Muni Catchup 8/29. Better managing the risks of exposure to issuers with significant pension underfunding is one of the benefits of using professional management for a muni portfolio.
Because of the growing risks to investors, this week I am going to quote myself (is that cheating?):
The fundamental reasons to use a professional investment manager are when the investor does not have the time or the necessary expertise to properly make those decisions themselves.
The Bottom Line
The consensus about when The Fed will raise rates seems to shift with the breeze, but one thing seems clear: when it happens, the yield curve is going to move, and the longer maturities could move by just as much–or more–than short maturities. Of course, longer bonds have higher durations and would therefore be at a higher risk of a decline in market value. In other words, maintain a caution stance as it pertains to maturity selection.
Curve: while there is an incremental pick-up by going out to about 15 years, the duration in that part of the curve can be around 12 or higher. While holding bonds to maturity can offset duration risk, for most, it may be prudent to focus on shorter durations. (Keep in mind that it is possible to be too short in duration–lower volatility will most likely also mean less diversification to offset equity risk.)
Credit: is the economy improving? If so, credit spreads should tighten, offsetting some of the price erosion caused by a potential increase in rates. It’s never a good idea to overload on any one source of risk, and credit risk gone bad can be especially painful to exit, but holding a modest amount of credit risk is reasonable given the current environment, and can add some incremental income as well as diversification. If you’re holding or are thinking about adding non-investment grade bonds, consider hiring a professional manager–either through an SMA, mutual fund or an ETF.
Structure: premium bonds should still be favored for their lower duration and higher cash flow. If rates do continue to tick higher, the higher cash flow will be available to reinvest at the higher prevailing rates.
Calls: rates could go lower, so beware of the total call risk in your portfolio. There are attractive opportunities right now for short call “kicker” bonds that would have higher yields to maturity if they don’t get called–but be sure that you are well compensated for that extension risk.
Products: muni bond mutual funds continue to have huge inflows. (Muni ETF flows have also been positive, but the dollar amounts are much less. See the Context page for recent data.) If those flows stop, that could take a lot of demand pressure out of the market, further pressuring muni prices. If the flows reverse, even investors who remain in those funds could get hurt by fellow shareholders heading for the exits.
Have a great week, and thanks for reading. Please let me know if you have any questions.