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Will Muni ETFs Lose Steam After a Superb Rally?

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Municipal bonds are excellent choices for investors seeking a steady stream of tax-free income. Usually, the interest income from munis is exempt from federal tax and may not even be taxable per state laws, making these especially attractive to investors in the high tax bracket looking to reduce their tax liability.

Though the tax reform (or cuts) initially put muni bonds under pressure, limitation on the deductibility of state and local taxes (the SALT deduction) from federal taxes for taxpayers of some states kept demand for munis strong. Taxpayers of seven states (California, Connecticut, Minnesota, New Jersey, New York, South Carolina and Wisconsin) were not been benefited that much by the tax overhaul (read: 4 Reasons Why Muni Bond ETFs Are Rallying in 2019).

Net new cash flows into municipal bond funds witnessed the best start to a year since record-taking began in 1992. Lesser supply failed to match the demand in early 2019. As a result, Xtrackers Municipal Infrastructure Revenue Bond ETF (RVNU - Free Report) , VanEck Vectors AMT-Free Long Municipal Index ETF (MLN - Free Report) , Invesco National AMT-Free Municipal Bond ETF (PZA - Free Report) returned about 8%, 9% and 11% in the past one year (as of Oct 17, 2019).

Will the Rally Fade Ahead?

U.S. state and local governments are on their way to sell bonds “at the fastest pace in almost two years” in order to take advantage of lower interest rates and strong investor demand. The Fed has been dovish this year with rate cuts enacted already, one in July and the other in September. Talks are rife that the U.S. central bank may enact another rate cut in October. The policy easing has kept the treasury yields at low levels (read: Chances of Fed Rate Cut in October Rise: Sector ETFs to Buy).

Municipal bond issuers are likely to sell $21.4 billion in debt over the next month, which is apparently the “highest visible supply since December 2017,” ahead of federal tax law changes from the start of 2018, per Bloomberg.

“The upcoming supply will add to the $289 billion in long-term bonds state and local governments have already sold this year, an 11% increase over the same period in 2018. This week is slated to be the busiest since December 2017, driven by refinancing,” as quoted on Bloomberg.

In 2018, new issuance dropped about 25% from the previous year, which led to the price gains in munis. However, with supplies poised to rise in the coming days, muni bonds prices may slump. Also, after a sturdy performance, some muni bonds have expensive valuation, specially the shorter-dated ones, per Invesco.

High-Yield Muni Bond ETFs Still Appear Better Bets

Still, investors who want to hold positions in this arena, might find high-yield muni bond ETFs appealing. This is because credit spreads or "default spreads” are narrowing for high-yield muni bond ETFs. Investors should note that “a credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality,” per Investopedia. Such higher yields, relatively lower default risks and tax exemption benefits may continue to help the space (see all municipal bond ETFs here).

VanEck Vectors High-Yield Municipal Index ETF (HYD - Free Report)

The underlying Bloomberg Barclays Municipal Custom High Yield Composite Index intends to track the overall performance of the U.S. dollar denominated high yield long-term tax-exempt bond market. It yields 4.18% annually. Effective duration of the fund is 6.32 years.

SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB - Free Report)

The underlying Bloomberg Barclays Municipal Yield Index is market value-weighted and designed to measure the performance of U.S. dollar-denominated high-yield municipal bonds issued by U.S. states, the District of Columbia, U.S. territories and local governments or agencies. It yields 4.00% annually. Option Adjusted Duration of the fund is 6.39 years.

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