High Yield Munis and the Tax DebateJim Colby, Portfolio Manager and Strategist, Municipal BondsMay 25, 2021
The benefits of tax-free bonds have gradually emerged as an important asset for an increasingly large number of investors, and its significance is directly tied to domestic tax policy. Compared to other fixed income products, tax-free income general is favored when either the nominal yield is the equivalent or in excess of taxable income. In addition, the measure of taxable equivalent yield is another way to view the relative value of tax-free bonds. As tax proposals are debated in Washington, Portfolio Manager Jim Colby discusses in this Q&A the potential impact of resulting tax legislation and how investors can position their portfolios accordingly.
Taxes may be going up. What does that mean for municipal bond investors?
What is currently being debated in Washington—with an outcome likely to increase personal taxes—may, in our view, further highlight municipal bonds as a potential favored asset class as individuals seek ways to shelter income. Discussions are still in early stages, but in addition to taxes, there are other financing vehicles—currently out of favor—that may become part of legislation to stimulate infrastructure investment using municipal bonds in a very significant way.
As we look at the proposals currently being debated, higher taxes may result in greater attention being paid to municipals. We believe this may lead to stable, if not higher, prices. This may also shine a spotlight on high yield municipal bonds, such as the exposure offered by VanEck Vectors High Yield Muni ETF (HYD®) and VanEck Vectors Short High Yield Muni ETF (SHYD®).
Though we cannot be certain, we believe the investing public appears to already be anticipating higher taxes and are currently favoring tax-exempt income solutions, based on fund inflows.
How are spreads and defaults in high yield municipal bonds currently, and why should investors consider allocating to high yield munis now?
Looking at data from Barclays going back around 20 years, whether comparing long to short maturities or BBB to AAA, spreads are trending tighter. Why? For the past two to three years, demand for municipal bonds has been increasing. Moreover, certain legislation passed to limit issuance of some types of bonds as well as a generally conservative approach by states and cities to hold down spending have led to insufficient bonds being issued to meet demand. Even as demand has grown in high yield, according to fund flow data from Morningstar, MSRB new issuance supply has not been strong enough to prevent spreads from narrowing.
Defaults remain significantly lower for municipal bonds than other investment classes, according to Moody’s Investors Services’ annual municipal bond market snapshot. This has been true for 20 years or more. Currently, high yield municipal bond defaults are actually on the decline as cities and states reemerge from some COVID-19 restrictions. Vaccinations and fiscal stimulus have provided the safety net that is allowing some projects to find their footing and remain viable entities, all of which speaks well to the prospects for muni high yield in the coming months and years.
How do VanEck’s high yield municipal bond offerings differ?
Our high yield municipal bond ETFs are designed to offer investors a choice to include credit risk and higher income producing opportunities as a complement to our yield curve-focused investment grade municipal ETFs.
SHYD is our short high yield ETF designed to take a little less interest rate risk than our broader and larger all maturity high yield portfolio, HYD. While both portfolios hold issues of similar underlying qualities, there are some important differences.
First, it is important to understand that the rules governing the construction of these portfolios’ indices are designed to provide the best opportunity for individual investors to participate in a marketplace that, because of its idiosyncrasies, can be difficult to navigate without specific expertise. As such, these portfolios are highly diversified, which is an important criteria, especially in high yield. In addition, by imbedding the portfolios into an ETF structure represented by shares traded on an exchange, we believe the liquidity for buyers and sellers is enhanced.
SHYD seeks to provide a certain degree of protection against interest rate moves with a lower duration profile than HYD—generally from 1.25 years to 3 years. Its average credit quality, by design, is slightly higher, historically offering a higher liquidity profile. Naturally, these features mean that the tax-exempt yield will be less than that of HYD. That differential was only about 0.97% as of May 24, 2021, but it can be as wide as 2.00%. Since we are not attempting to outperform the market, the measure of success for these ETFs is based upon matching up the specific holdings to the characteristics of the indices, which is our investment objective. We carefully position bonds such that the weights of bonds issued from different states, for example, are as close to that of the underlying indices as possible. No less important are the credit ratings and sectors into which these bonds fall.
What is the overarching investment philosophy behind VanEck’s municipal bond ETFs?
VanEck’s overall approach to municipal bonds, initiated some 14 years ago, was to design a suite of municipal bond ETFs to capture the wide range of market opportunities in the municipal market that are both rates and credit based. Our suite of muni ETFs began with three investment grade portfolios, VanEck Vectors®Short Muni ETF (SMB®), VanEck Vectors Intermediate Muni ETF (ITM®) and VanEck Vectors Long Muni ETF (MLN®), complemented by our high yield ETFs, HYD and SHYD.
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