What's missing from passive muni ETFs?
Some of the largest municipal bond ETFs are passively managed, but did you know that these index-tracking funds exclude a significant portion of the muni bond market?
The municipal bond ETF marketplace has long been ruled by index-tracking funds, providing investors with low-cost access to a wide swath of the municipal bond market. Notably, the two largest ETFs in this category are passively managed and account for nearly 75% of overall municipal bond ETF assets.1 While passive ETFs, including these giants, are attractive due to their low fees, these funds miss out on some compelling areas of the municipal bond market due to the rules that define their construction.
What sectors are often excluded from passive muni ETFs?
By design, a passive ETF’s portfolio is tied to its underlying benchmark. Examining the rules governing these benchmarks can shed light on which segments of the municipal bond market aren’t represented within their associated ETFs.
Commonly excluded areas of the market include housing bonds, tobacco bonds, and bonds that are subject to the alternative minimum tax. Conduit bonds, which are a specific type of municipal bond issued by a governmental entity but primarily for the benefit of for-profit institutions like hospitals and universities, can also be excluded from the index. Due to these exclusions, it’s estimated that the largest passive municipal bond ETFs lack exposure to around one-fifth of the municipal bond market.
Passive ETFs can exclude a significant portion of the municipal bond market
What are the potential benefits of active municipal bond ETFs?
Due to their specialized nature, bonds in these excluded sectors can often exhibit lower liquidity and higher price volatility, especially during periods of market stress. However, these niche municipal bonds can potentially offer attractive yields compared to more traditional areas of the municipal bond market. These elevated yields serve as compensation for the additional risks associated with investing in less liquid sectors of the muni market.
We believe one of the key benefits of active municipal bond ETFs is the knowledge and expertise brought by their portfolio management teams, who can research individual municipal bond issues, identifying solid opportunities within these sectors that are often left out of passive muni ETFs.
Beyond the possibility for alpha from security selection, these portfolio managers can also play a crucial role in mitigating the higher risks these sectors may exhibit during a recessionary period or market sell-off. By dynamically adjusting exposures to these areas of the market depending on the team’s economic outlook, these ETFs have the flexibility to navigate the complexities of these specialized sectors, offering investors a potential advantage.
Where are we seeing value today?
In our view, some of the most promising opportunities in the municipal bond market can be found in areas that are often excluded from most passive ETFs. Specifically, the healthcare and higher education industries are facing mounting economic, regulatory, and competitive pressures. These challenges, however, are also creating an environment of increasing consolidation. We believe that identifying and investing in bonds issued by potential takeover candidates within these industries presents a unique opportunity. As these entities merge, they often achieve enhanced financial stability along with operational efficiencies, making their bonds more secure.
Positioning for seasonality
The municipal bond market is influenced by seasonality—predictable patterns or trends that affect bond prices, yields, issuance volumes, and investor behavior. One such pattern that tends to emerge during an election year is a slowdown in issuance ahead of the presidential election.
So far, we’ve mainly observed this trend within the high-yield sector of the municipal bond market. New issuance in this segment has been a fraction of what we typically see in a year. This lack of supply, coupled with strong demand as $11.2 billion has flowed into high-yield municipal bond funds year to date, has led to this asset class outperforming all other domestic fixed-income segments as of the end of August.
High-yield municipal bonds have outperformed other areas of the bond market this year
Year-to-date performance through 8/31/24
While the largest passive muni ETFs are limited to investment-grade issues, actively managed ETFs have the flexibility to invest across the credit spectrum. Portfolio management teams can allocate to the high-yield sector to capitalize on these technical factors. Recently, ETFs that have been able to dip into lower-quality municipal bonds have seen a performance advantage as high-yield municipal bonds have outperformed investment-grade issues even amid the recent equity sell-off.
Why active management matters in municipal bond ETFs
Unlike their passive counterparts, active ETFs are equipped with a broader set of tools that allows fund management teams to navigate the municipal bond market’s unique quirks and seize opportunities that may be overlooked by a rigid, index-following strategy.
By leveraging the management team’s insight, shifting asset allocation, and dynamically managing risk, actively managed ETFs have the flexibility to invest across all areas of the municipal bond market. This approach offers investors not just a more well-diversified portfolio but also the possibility of enhanced returns.
1 ETF.com, as of 8/23/24.
Important disclosures
Investing involves risks, including the potential loss of principal. There is no guarantee that a fund’s investment strategy will be successful. Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Investments in higher-yielding, lower-rated securities include a higher risk of default. Municipal bond prices can decline due to fiscal mismanagement or tax shortfalls, or if related projects become unprofitable. It’s possible that an active trading market for fund shares will not develop, which may hurt your ability to buy or sell fund shares, particularly in times of market stress. Trading securities actively can increase transaction costs, therefore lowering performance and taxable distributions. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions. To the extent that the fund invests in bonds that are subject to the alternative minimum tax (AMT), the income paid by the fund may not be entirely tax-free to all investors. Tender option bonds use leverage that magnifies both positive and negative returns, which increases the fund risk by magnifying the volatility of returns and could lead to termination of the Tender Option Bond trust. In that event, the fund may sell assets to purchase the trust’s floating-rate security, which could negatively affect fund performance or liquidate the trust’s assets. Fund distributions generally depend on income from underlying investments and may vary or cease altogether in the future. Shares may trade at a premium or discount to their NAV in the secondary market. These variations may be greater when markets are volatile or subject to unusual conditions. Please see the fund’s prospectus for additional risks.
The views presented are those of the author(s) and are subject to change. There is no guarantee that any investment strategy illustrated will be successful or achieve any particular level of results. This is for informational purposes only and is not intended to be, nor shall it be interpreted or construed as, a recommendation or providing advice, impartial or otherwise, regarding any security, mutual fund, ETF, sector, or index. Investors should consult with their financial professional before making any investment decisions. Past performance does not guarantee future results
The Bloomberg High Yield (HY) Municipal Bond Index tracks the performance of municipal bonds rated below investment grade (BBB/Baa) and those that are unrated. The Intercontinental Exchange Bank of America (ICE BofA) U.S. High Yield (HY) Index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds in the U.S. domestic market and includes issues with a credit rating of BBB or below. The ICE BofA Corporate Index tracks the performance of U.S. dollar-denominated investment-grade corporate debt in theU.S. domestic market. The Bloomberg U.S. Mortgage-Backed Securities (MBS) Index tracks the performance of 15- and 30-year fixed-rate securities backed by the mortgage pools of Ginnie Mae, Freddie Mac, and Fannie Mae. The Bloomberg U.S. Treasury Index tracks the performance of U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. The Bloomberg Municipal Bond Index tracks the performance of the U.S. investment-grade tax-exempt bond market. It is not possible to invest directly in an index.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Alpha measures the difference between an actively managed fund's return and that of its benchmark index. An alpha of 3, for example, indicates the fund’s performance was 3% better than that of its benchmark (or expected return) over a specified period of time.
Investment grade is a rating indicating that a municipal or corporate bond carries a relatively low risk of default.
JHS-602031-2024-09-05