The chart below is not a pretty sight. The US municipal bond market started a massive leg down on November 8th which has now turned into what looks like an all-out collapse. In the space of a week and a half, the iShares S&P National Municipal Bond Fund (MUB) which is the largest ETF for the US municipal bond market with a market cap in excess of $2 billion, has fallen by 4.55%. This may not sound like much compared to equity market movements, but it is a huge move in the muni market, as is evident from all the tiny daily moves in the chart above before November.
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Municipal bonds have traditionally been held widely amongst tax-sensitive investors, especially those in higher marginal tax brackets. This is because municipal bonds provide income that is free from federal taxes and often from taxes of the state in which they are issued. However, since 2008, many states and municipalities in the US have had trouble keeping their budgets in line and have suffered large deficits. A prime example is, of course, California. Due to California’s budget problems, the state’s bonds have suffered badly. In fact, since November 8th, CMF, which tracks an index holding municipal bonds issued in California, has fallen much more than MUB, dropping close to 6%.
What is behind the panic?
Interestingly, most commentators haven’t been able to pin-point any one single trigger that may have sparked the sell-off in the general muni bond market. However, there are plenty of underlying problems that have been festering in the market for a while.
First off, as mentioned earlier, nearly every state in the US has had trouble balancing its budget and budgetary problems have reduced confidence in the ability of the issuers to meet their debt obligations. California will be auctioning off $14 billion in bonds this month to help bridge its deficit gap, in turn creating an over-supply of bonds when demand for them is dropping. Another reason speculated to be behind this recent move down has been the pending closure of the Build America Bond program. The program has been hugely successful since its launch as issuers capitalized on a cheaper way to finance their capital needs because of the credits they receive on interest payments from the government. The program though is due to expire at the end of 2010 and there has been no word on previous discussions in the US Congress of extending this program till the end of 2012. Due to the upcoming deadline, states and municipalities are rushing to issue bonds under the program, again causing a supply glut.
How do Active Muni ETFs stack up with Passive Muni ETFs?
One good opportunity that this panic does provide us with is an ideal testing ground to evaluate whether active management adds any value in times like this. In other words, are active managers earning their marks in times when they would be expected to. There are currently two actively-managed ETFs in the US that compare well, in terms of maturity, with the iShares S&P National Municipal Bond Fund (MUB) which can be taken as the passive proxy – PIMCO’s Intermediate Municipal Bond Fund (MUNI) and the Grail McDonnell Intermediate Municipal Bond ETF (GMMB). The chart below shows how the 3 funds have fared in the last month.
Where MUB has fallen in excess of 5% in the last 1 month, MUNI and GMMB have been able to restrict their losses to about 2%. So at least in this panic situation, it appears that whatever active decisions that the managers made helped them avoid the worst of the downfall.
What explains the outperformance?
But what are the specific differences between MUB and PIMCO’s MUNI for example, that helped MUNI outperform. For one thing, the portfolio managers behind MUNI are not obliged to hold every single security in the index regardless of the credit quality of the issuer. This fact shows up in the portfolio composition of those two ETFs. Where MUB held a whopping 1,144 bonds as of Nov. 16th, MUNI held a select 98 securities and GMMB held an even narrower selection of 22 securities. In terms of its top holdings, because it follows a cap-weighted index following the municipal bond market, it should come as no surprise that the largest holding of MUB was a California State Bond.
This is the classic “bums” problem that is a favourite argument of the fundamentally-weighted indexing proponents. Cap-weighted indices like the one that MUB tracks give more weight to issuers that issue more debt – in this case California. As a result, investors holding MUB end up with California bonds as their biggest holdings at a time when they are probably the riskiest. To prove the point, just over the past month, CMF – an ETF which tracks the California municipal bond market – has underperformed NYF – which tracks the New York municipal bond market – by more than 1.5%. So in contrast to MUB, a California issued bond was not to be found in MUNI’s top 10 holdings. That should provide some indication of the value of credit analysis done by active managers from PIMCO for MUNI and from McDonnell Investment Management for GMMB.
How do Premium/Discounts compare?
Another area where the actively-managed ETFs seem to be performing better in this panicked market is in keeping the discount/premium from NAV to a minimum. In general, ETF shares trade at a premium to NAV when demand is high and trade at a discount to NAV when the demand is low. Bond ETF discounts were a big problem in 2008 when credit markets locked up. At one point in October 2008, the largest bond ETF at that time, iShares Lehman Aggregate Bond ETF (AGG), traded at an 8.9% discount. Hence, that discounts in bond ETFs are definitely another metric that needs to be assessed in times of market stress.
According to the iShares’ website, MUB had a discount of 186 basis points to its NAV at the close on Nov. 16th, a substantial discount given that the largest discount recorded for MUB in 2010 up till September was just 16 basis points. In comparison, PIMCO’s MUNI had a premium of 6 basis points as of market close on Nov. 17th, a substantial difference. Grail’s GMMB though had a harder time, but still fared better than MUB as Grail’s website reported GMMB having a discount of 161 basis points as of Nov. 17th.
Disclosure: No positions in above-mentioned names.
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