James Colby is Van Eck Global's senior municipal fixed-income strategist. His 28 years of experience in the industry also include serving as a muni director at Lord, Abbett; John Hancock Funds; and Evergreen Asset Management, among others.
On Friday, IndexUniverse.com's Murray Coleman caught up with Colby to discuss recent developments in muni bond markets and the role exchange-traded funds are playing.
IU: Are bond ETFs helping to set prices and improve liquidity in municipal markets?
Colby: Bond ETFs have helped to maintain, if not improve, liquidity. Muni ETFs, as a group, are only a year and a half old. They were thrust into the marketplace at a period we'll all look back upon as a seminal point in the fortunes of Wall Street. We were simultaneously hit with subprime woes and corresponding auction-rate securities problems. The demise of the single-purpose bond insurer also took place at this same time. With all of that as a backdrop, muni ETFs certainly came to market at a time of tremendous strain and tension in our capital markets.
IU: What have ETFs proven so far?
Colby: For one, they've definitely proven an ability to attract investors. That fact is supported by the asset growth we've seen in muni ETFs despite such an incredibly difficult market environment. We've gone from zero assets under management to over $2 billion in 18 months. I would call that a victory.
IU: Have muni ETFs shown any shortcomings?
Colby: What's yet to be proven is the full promise of what ETFs can deliver. They can definitely deliver improved pricing and price discovery as well as greater transparency. But it hasn't happened yet in the context of being able to transact in a reasonably efficient and orderly market.
IU: Once markets return to more normal circumstances, do you see muni ETFs helping investors in other ways?
Colby: Yes, I do. It's important to note that the muni marketplace is about $2.7 trillion in U.S. market value. At the same time, there's no exchange for munis—they're still traded as an over-the-counter asset. So transparency in terms of price discovery remains as murky as ever. With ETFs, however, a financial model has been created to price municipal bond portfolios every 15 seconds of every day that an exchange is open. That point has sort of been lost in the fog of the turmoil in the marketplace. But the model that is in place for pricing muni ETFs—as imperfect as some may view it—has indeed established a basis for specialists to make markets.
IU: How is the growth of muni ETFs impacting costs for investors?
Colby: It might cost an investor in fees and related expenses anywhere from 2-4% to purchase or sell an individual muni security. Mutual fund muni fees range anywhere between 60-120 basis points in average costs. Contrast that to the transparency and low cost of muni ETFs, which have expense ratios ranging from 16-35 basis points. So ETFs really are driving down costs for all types of investors to participate in this market.
IU: But aren't muni funds typically used only by upper-income investors?
Colby: Over the years, the perception has been that munis are for high net worth investors. In fact, for investors in the lower tax brackets, there are very attractive opportunities that might now be realized with the use of ETFs. And there are plenty of Web sites that you can use to compare the taxable equivalent of munis to taxable bonds.
IU: How does the current muni market look in that regard?
Colby: Here's an example. As of March 5, the SEC 30-day yield of the Market Vectors Intermediate Muni ETF (ITM) was 3.87%. At a 15% tax bracket, the taxable equivalent yield would be 4.56%. In the 25% tax bracket, it would be 5.16%. At the 35% bracket, it jumps to 5.96%. The average maturity of this fund is 11 years. If you take an 11-year Treasury note, you're earning around a 3.50-3.60% yield.
IU: How about comparing corporate issues?
Colby: With corporate spreads being what they are, you're not going to get an equivalent maturity and equivalent-rated security anywhere close to that 6% tax-equivalent yield. Even at lower tax brackets, muni yields are very competitive.
IU: Fundamentally, what is the situation with state budget deficits and muni credit quality?
Colby: If there's any one overwhelming concern, it's credit quality. What Moody's and S&P are contemplating doing is re-rating some of the significant issuers in the marketplace. There may be downgrades in the offing if the government's recovery efforts to stimulate the economy don't prove effective. And we're talking about a need for those stimulus plans to positively impact state and local governments in the next six to 12 months. The hope is that money coming to the states will prevent any further erosion in their budget situations. The question is whether this stimulus package is going to be enough and whether it can happen quickly enough to help support local economies.