Market Vectors High-Yield Municipal Index ETF (NYSEARCA:HYD) according to Yahoo, seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Barclays Municipal Custom High Yield Composite Index (the "High Yield Index"). The fund normally invests at least 80% of its total assets in securities that comprise the benchmark index. The High Yield Index is comprised of publicly-traded municipal bonds that cover the U.S. dollar denominated high yield long-term tax-exempt bond market. The fund is non-diversified.
We decided to dig in a little deeper to understand this ETF, its yield, tax implications, exposure to Puerto Rico, and whether the yield is worth the risk, in a rising or falling interest rate environment.
The Barclays High Yield Composite Index or LMEHTR is calculated using a market weighting methodology and it tracks the high-yield municipal bond market with a 75% weighting in non-investment grade municipal bonds and a 25% weight in Baa/BBB- rated investment grade municipal bonds for liquidity and balance. The index is rebalanced on a monthly basis.
It must be recognized that though the fund is considered a passive ETF, the fund managers are not obligated or required to replicate all the issues in the index. The index itself has 4,364 issues but the ETF has only 590, as of July 31, 2014. The fund managers can use their own approach or what is termed a sampling strategy and disclose that to investors. This method of management, goes back to the basic tenet of Portfolio Management. Simply because it is a passive investment does not mean changes are never made to the portfolio, it simply means the portfolio is not actively traded for outsized returns above a benchmark or index. That is exactly what the fund managers did this past Spring. At the start of the year the fund had only 5% of its holdings in Puerto Rico. Following the ratings downgrade, this past spring the index had seen its Puerto Rico exposure jump to 30%. It is now below 5%, and the fund itself has only 3.88% of its holdings, as of July 31. In fact the ETF's exposure to Puerto Rico is not a significant factor. We will discuss the entire Puerto Rico issue and its implications for all municipal investors at another time.
Here is a brief current breakdown for information purposes:
Fund Top Geographic Breakdown
- California 8.80%
- New York 7.08%
- Texas 6.70%
- Florida 6.40%
- Ohio 5.48%
- New Jersey 5.28%
- Illinois 4.59%
- Arizona 4.01%
- Puerto Rico 3.88%
- Virginia 3.67%
Before we get to the all important performance and tax benefits, let's breakdown the ratings of the holdings and describe what may actually not be high risk (or high yield) when an investor believes it is high risk. As of July 31, the fund had 25.86% of its holdings in investment grade and above, 42.82% in lower rated paper or "junk," and 26.70% as non-rated and 4.62% considered unassigned for a total of 31.32%. This does not mean that an additional 31.32% of the fund could be lower rated quality or "junk." This simply means that the issuers, in many cases small municipals or corporates that stand behind the IDA (Industrial development Authority) projects did not care to apply for a rating. As many people learned during the credit crisis simply because an issue was highly rated or appeared to be highly rated does not make it a high quality issue. As such, the alternative applies and always does apply as well. Many of these small borrowers do not want to pay for the privilege of having the issue rated investment grade. Many people ask, why? It is rather simple. They must pass the costs on to the borrowers (with a corresponding higher coupon or face interest rate), thus pushing up their own cost of capital. Even if it is only a small amount many of the issuers prefer to be unrated, especially for small issues. It is also very difficult for most investors and their advisors to source these issues. The overall liability is of course, high for the advisors, not to mention time consuming. Many large firms do not encourage or compensate their representatives for the additional due diligence needed to examine these unrated issues and in general, do not provide it. As such, we look at this ETF as a good choice with its high percentage of unrated paper. Some of its "larger" holdings include Overland Park Kans Dev Corp Rev 5.125 1/01/32 with 1.60% and Sanger Tex Indl Dev Corp Indl Dev Rev 8.000 7/01/38 with 1.00%, respectively in the ETF. All other holdings are below 1.0% of the AUM. As such, the exposure to particular issues is extremely minimal and the risk is disseminated amongst various issues.
In terms of the fund sector breakdown, for information purposes, here are the top sectors:
- Industrial Revenue/Pollution Control 34.90%
- Health Care Facilities 29.37%
- Transportation Infrastructure 10.81%
- Education 6.84%
- Special Tax 5.34%
- Water Utilities 4.02%
- [Unassigned] 1.90%
- Leasing 1.81%
- State General 1.36%
- Power Utilities 1.28%
- Local General 1.18%
- Housing 0.66%
- Resource Recovery 0.53%
In terms of the infamous "WET" bonds, 22.95% of the fund is in this category. What that means for investors is a high assurance of payment on those issues and a general implied lower overall risk. For those inexperienced in municipal debt, "WET" bonds are considered bonds that are connected to or derive revenue from Water, Electricity, and Transportation. Some investors state that "Education" can also fit here. As such, we will include it. The key point is this debt category or related debt has a high public need and would be the last type of debt to default, due to future ramifications for borrowing, constant public need, and "greater good."
In addition, as noted 34.90% of is in Industrial Revenue/Pollution Control sector. These bonds are revenue bonds organized and in a conduit or venture with a local or state municipality. Industrial Development Bond (IDB) financing allows a private user, i.e. manufacturing company, to benefit from the government's status as a tax-exempt entity and its ability to issue debt obligations at tax-exempt rates. As the ultimate recipient of the proceeds of the bonds, the private user benefits because the interest on the obligations is tax-free exempt and therefore bears a lower interest cost than comparable taxable financing.
For example, IDBs may sell at rates 30% below Prime on a variable interest rate basis or 2-4 percentage points lower than taxable alternatives. The existing format finalized over the last 25 years have allowed it to become available in every state. One of the interesting aspects of IDB's is that they are typically issued through state or local Industrial Development Bond issuers on a "conduit" basis, meaning the issuer does not back or secure repayment on the bonds. As such, a corporation would issue them and again, if they applied for a rating this would most likely push up the cost of borrowing for the issuer. In addition, specific rules apply with both the municipal and the corporation under the tax code. Many of the issues are under $1M and others are up to $10million. In this case, the issue is simply too small and it would be too costly for the municipal authority or corporation to apply for a rating.
The bonds are sold primarily to funds, institutions, and high net worth investors who understand the nature of the investment or are thoroughly explained the risks and nuances of the corporation and project. In addition, the tax free revenue to the investor may be partially taxable. The main reason is since the proceeds from the bond issue are being used to finance projects with a for-profit corporation the issue may be labeled Alternative Minimum Tax or AMT. Presently 12.92% of HYD is AMT.
Returning to the sector risk of the ETF, we find a total of 57.85% of the bonds in are either in Industrial Revenue/Pollution or WET bonds. This adds a great comfort level in terms of sector risk of this ETF. As mentioned previously, the first two names of the largest fund holdings are IDBs. For information purposes here are the largest holdings:
Top Ten Holdings
- Overland Park Kans Dev Corp Rev 5.125 1/01/32 1.60%
- Sanger Tex Indl Dev Corp Indl Dev Rev 8.000 7/01/38 1.00%
- Jefferson Cnty Ala Swr Rev 6.500 10/01/53 0.97%
- Foothill / Eastern Transn Corridor Agy Calif Toll Rd... 5.500 1/15/53 0.96%
- Salt Verde Finl Corp Sr Gas Rev Ariz 5.000 12/01/37 0.91%
- South Carolina Jobs-Economic Dev Auth Hosp Rev 5.250 11/01/36 0.82%
- Metropolitan Wash D C Arpts Auth Dulles Toll Rdrev 5.000 10/01/53 0.79%
- Texas Mun Gas Acquisition & Supply Corp I Gas Supply... 6.250 12/15/26 0.78%
- New Jersey Economic Dev Auth Rev 6.625 1/01/37 0.76%
- Buckeye Ohio Tob Settlement Fing Auth 5.125 6/01/24 0.76%
In terms of Assets Under Management the fund had 823M in February, $979.77M at the end of April and presently has $1,097B in AUM. Obviously, there has been an uptick in AUM as yield-hungry investors (both institutional and retail), seek out yields at interest rate lows. We can only see this continuing.
In terms of returns, the fund has a YTD return of 10.48% at the share price and a one-year return of 6.94%, as of July 31. The fund has a coupon (face interest rate) of 5.65% and the 30-day SEC yield is presently 5.01% which is equivalent to approximately 8.30% in the 39.6% tax bracket. Of course, as I mentioned 12.92% of the fund fits into the AMT category for tax purposes, so this yield is lower for those who are categorized as AMT. Last year the fund had a loss for the 12 months ending December 2013 at 8.73%. One of the primary reasons was potential defaults at city levels, i.e. Detroit and heavy debt exposure to Puerto Rico amongst others. But as we mentioned, the fund has rebalanced, and come back very well this year. In addition, in spite of a plethora of long-term debt in the average maturity is 21.94 years (20.30 years for the underlying index), this duration is attractive. The duration is a reasonable 7.15 years (7.01 for the index). This would place it into a medium-term structure and not be considered an extremely look term ETF. Though an ETF of this size would experience a significant pull back in a rising rate environment, the portfolio managers have rebalanced it well after the Puerto Rico and Detroit downgrades and the duration is attractive. Obviously, there are others who feel that municipals may be under further pressure if credit conditions decrease or deteriorate. Our opinion is that baring a rising rate environment for long-term debt, we see an attractive ETF and should be purchased for both tax free yield and total return investors. With a low expense ratio of 0.35%, and trading near its year high of $30.58, we highly recommend a buy with an attractive tax free cash flow and a six-month price target of $33.00. This would represent a capital gain of approximately 8.50%, a tax free return of approximately 5.0% and a total return of approximately 13.50%
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