Short-Term, High Yield Municipal Bond ETF

Jan.28.14 | About: VanEck Vectors (SHYD)

On January 14, Market Vectors launched a new ETF, the Market Vectors Short High-Yield Municipal Index ETF (NYSEARCA:SHYD), which seeks to track the performance of the Barclays Municipal High Yield Short Duration Index. Only tax-exempt municipal bonds with a nominal maturity of 1 to 10 years are included in the index, and 75% of the index consists of below investment grade municipal bonds. For added liquidity, investment grade municipal bonds have the remaining 25% weighting in the index. SHYD has a total annual operating expense ratio of 0.35 percent. The fund's yield to worst is 5.02% and has an average portfolio maturity of 8.16 years.

Municipal bonds have had a bad year in 2013, as Detroit filed for bankruptcy in July and yields have risen as the investors grew increasingly concerned over the Fed's tapering of asset purchases. Although, municipal bonds generally carry higher credit risks than U.S. Treasuries, there have been very few cases of default. Yields on municipal bonds have remained high on concerns over their higher credit risks, as some states and local governments are struggling to balance their budgets amid rising pension liabilities and higher healthcare costs, whilst tax receipts remain low. But with the risk of default in the medium term being confined amongst very few bond issuers, high yielding municipal bonds are attractive to the less risk averse investor.

There are existing ETFs which track the U.S. municipal bond market, including the iShares S&P National Municipal Bond Fund (NYSEARCA:MUB) and the SPDR Nuveen Barclays Capital Short Term Municipal Bond ETF (NYSEARCA:SHM). But, none of them specifically track the high-yielding and short duration municipal bonds, which have recently become particularly attractive.

As of December 31, 2013, bonds issued by Puerto Rico represent 11.5% of the fund's portfolio. Puerto Rico general obligation bonds are just one step above junk status, and credit rating agency, Moody's, have placed its rating on review for downgrade. With debt totaling $70 billion, Puerto Rico's debt load is larger than that for any state, except for California and New York, despite its small population. The origins for the chronic budget deficit stems from the expiry of federal corporate tax exemptions in 2006, which effectively led to an eight year long recession as jobs continued to recede. To make matters worse, Puerto Rico also has an estimated $33 billion in pension liabilities. The uncertainties surrounding Puerto Rico's finances are unlikely to go away anytime soon; but Governor Padilla has made some progress to reduce the budget deficit, including raising taxes and passing through some much loathed pension reforms.

Bonds with shorter durations are particularly attractive as the Fed tapers asset purchases, leading to increasing expectations of higher interest rates. With an improving U.S. economy and generally improving budget outlooks in most cities and states; there is significant potential for the yield spread between higher-yielding municipal bonds and triple-A rated municipal bonds to narrow in the medium term. In addition, Michael Cohick, product manager with Market Vectors, noted that credit spreads between investment grade and high yield short duration municipal bonds tend to be wider than the spreads found among longer maturity municipal bonds. It therefore seems that this ETF was specifically created for today's current market conditions.

The Market Vectors Short High-Yield Municipal Index ETF offers an attractive solution for investors who are expecting further recovery in the municipal bond market, and those in search for higher yields without taking on too much interest rate risk. But, for the higher yield, the risk of default is also higher.

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