Fixed income investors should take another look at Muni Bond ETFs

Municipal bonds and related exchange-traded funds took a beating in 2022, but fixed-income investors shouldn’t write off this struggling segment of the bond market.

A combination of rising interest rates and elevated inflationary pressures weighed on equity and bond markets, with fixed-income assets having one of their worst first halfs since the early 1990s.

As fixed income markets retreated, municipal bonds were among the hardest hit and saw one of their worst sales ever.

“Yet municipal bonds have historically shown that they can reverse course quickly, unlike other pockets of the bond market. Just recently, we have seen greater stability in the municipal market, with investors starting to return to take advantage bargains,” Catherine Stienstra, head of municipal investments at Columbia Threadneedle Investments, told MarketWatch.

Specifically, Stienstra highlighted four supporting factors that should help the munis segment rebound, including better adaptability in a rising rate environment, seasonal tailwinds, improving fundamentals and reduced credit risk. .

Stienstra explained that munis have historically outperformed other fixed income assets during periods when the Federal Reserve has raised interest rates, as the yield curve flattens during rate hike cycles and creates opportunities for more attractive income and total return, especially on future-maturity debt.

Munis may also experience a seasonal tailwind after tax season. The tax-exempt municipal bond segment is typically used by high-income and retail investors, and bonds will generally come under greater selling pressure ahead of tax season to pay taxes or reap tax losses.

Improving fundamentals or increased demand outpacing tighter supplies could help support the muni market, as many muni bonds will mature over the summer period or pay coupons to investors. Returns can be reinjected into the muni market as investors reinvest. Local governments also issue less new debt during the summer.

Finally, Stienstra noted that many state and local governments are cash-rich and running budget surpluses, so there is less credit risk in the muni segment and default expectations are at an all-time low.

“After taking into account the effect of taxes, the taxable equivalent yield of municipal bonds is particularly attractive,” added Stienstra.

ETF investors interested in the muni space can also consider targeted ETF strategies, such as the popular Vanguard Tax-Exempt Bond ETF (VTEB), which costs 0.05%. The fund, which tracks the US muni space via the S&P National AMT-Free Municipal Bond Index, has generated $4.26 billion in net new assets year-to-date.

For more news, insights and strategy, visit the Fixed Income Channel.