Short High-Yield Municipal Index ETF, An Undiscovered Value

Aug.27.14 | About: VanEck Vectors (SHYD)


An attractive yield, nicely balanced, and a short duration, looks good if rates tick higher.

With only $60.37M in AUM, where are the hedge funds and institutional investors?

We will analyze this young ETF and discuss a new worry for retail ETF buyers.

Short High-Yield Municipal Index ETF (NYSEARCA:SHYD) is an attractive ETF with a reasonable yield and short duration. It is truly "under the radar", and we only discovered it after one of our readers brought it to our attention. We will do a brief analysis of it, covering its positives and negatives, and also discuss a recent negative development in the ETF space, especially in high-yield ETFs.

According, to Yahoo, SHYD seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Barclays Municipal High Yield Short Duration Index. The fund normally invests at least 80% of its total assets in securities that comprise the benchmark index. The index is composed of 1,449 publicly traded municipal bonds that cover the U.S. dollar-denominated high-yield short-term tax-exempt bond market. It is non-diversified. Presently, the fund is comprised of only 169 issues from the index, and has an annual operating expense of .35.

The fund began on January 13 of this year. As such, it only has a 7+ month life. In terms of the rating structure of the fund, presently, the fund has slightly over 48% in investment-grade or above. This gives us a comfort level in terms of credit risk. In addition, NR (non-rated) or unassigned total almost 22%. As I mentioned in my previous article on Market Vectors High-Yield Municipal Index ETF (NYSEARCA:HYD), many of these issues are small IRB (Industrial Revenue Bonds) issues and are backed by corporations. As such, they do not feel it is necessary to apply for a rating, due to the costs of rating the debt and the small issue sizes, generally $1-10M.

As a refresher for those that missed my last article, according to the CDFA spotlight,

"Industrial Development Bonds are really corporate bonds disguised to look like municipal bonds. Industrial Development Bond (IDB) financing is a technique whereby a state or local government allows a private user, like a 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-exempt and therefore bears a lower interest rate 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. This "conduit" financing technique has been around for more than 70 years, but only over the last 25 years has it become readily available in almost every state. IDBs are typically issued through state or local Industrial Development Bond issuers on a "conduit" basis, meaning the issuer does not back or secure repayment of the bonds."

Based upon this fact, we now have a combined total of slightly over 70% in investment-grade and non-rated municipals. As such, our comfort level has risen significantly. This leaves only approximately 30% in actual high-yield or "junk" paper. Let's break this paper down before we look at duration, return and the interesting update on ETFs I mentioned.

For information purposes, here is the sector breakdown:

  • Industrial Revenue/Pollution Control 33.80%
  • Health Care Facilities 23.00%
  • Transportation Infrastructure 9.08%
  • Special Tax 8.17%
  • Water Utilities 6.19%
  • Power Utilities 5.13%
  • Education 3.40%
  • Leasing 3.17%
  • Local General 2.87%
  • State General 2.65%
  • Resource Recovery 1.90%
  • [Unassigned] 0.38%
  • Housing 0.25%

The percentage of "WET", or Water, Electricity/Education and Transportation, is 23.8%. As I mentioned in my previous article on HYD, these bonds are a necessity for the "greater good" and highly unlikely to default or have issues. There is a logic there also, as one of my mentors once told me. "A municipality is highly unlikely to turn off the water or electricity or close the schools in a worse case and not make their payments." While this statement is simplistic, there is a logic to it, even if these agencies have issues. We will not discuss the city of Detroit and its recent controversial decision to turn off water on delinquent account holders. That is a whole other issue.

As such, the comfort level of the fund is similar to HYD, and we have a high confidence that the issues will mature at par and make all regular payments on a timely basis. If we add this figure to our 33.8% of IDBs, we come up with a total amount of 57.6%, and if we add our GO (general obligation) bonds, we come up with a total figure of slightly over 63%. GO bonds are almost always a good choice, since tax revenue and other revenue is used for payment on these issues. As such we have a high confidence in sector risk for SHYD.

One person asked me why I do not include healthcare or healthcare facilities in my analysis. It is a good question, and I will address it. This is the very risky sector of the holdings. In 2013, 18 acute-care hospitals have closed their doors. Of these, 14 were in rural areas. There are many others in serious financial condition, and both consolidation and closures will continue. I will not address the reasons in this analysis at this time. There are many. As such, it is quite appropriate to place many of these issues in the high-yield or junk category, with 23% of these issues within the fund. This is logical deduction considering that the fund has 29.8% in high-yield or "junk" bonds.

For information purposes, the geographic breakdown of the fund is as follows:

  • Texas 11.89%
  • New Jersey 10.88%
  • Ohio 9.56%
  • California 7.91%
  • Louisiana 6.92%
  • New York 5.78%
  • Illinois 5.30%
  • Arizona 4.87%
  • Michigan 4.59%
  • Wisconsin 4.26%

We were a little surprised at this structure. There are many short-term, project-based financings of industrial nature and municipal issues of a shorter nature in general in Texas, New Jersey and Ohio. These three states alone total over 32%, or almost a third of the fund's holdings. Keep in mind that Texas, with almost 12% of the fund, has no corporate or individual income tax.

Before we address the duration, return and a new development, let's give a brief breakdown of the issues:

  • Texas Mun Gas Acquisition & Supply Corp Iii Gassuppl... 5.000 12/15/21 3.76%
  • Buckeye Ohio Tob Settlement Fing Auth 5.125 6/01/24 2.77%
  • Salem Cnty N J Pollutn Ctl Fing Auth Pollutn Ctlrev 5.000 12/01/23 2.37%
  • Arizona Health Facs Auth Hosp Sys Rev 5.000 2/01/20 2.37%
  • New Orleans La Sew Svc Rev 5.000 6/01/19 2.32%
  • Railsplitter Tob Settlement Auth Ill Tob Settlement Rev 5.250 6/01/20 2.18%
  • Arizona Health Facs Auth Health Care Facs Rev 5.100 10/01/22 1.96%
  • Virgin Islands Pub Fin Auth Rev 5.000 10/01/20 1.92%
  • Michigan St Strategic Fd Solid Waste Disp Rev 7.500 1/01/21 1.90%
  • Oyster Bay N Y 3.000 8/15/18 1.90%

One can notice that these are attractive "coupons" with reasonable short-term maturities (as the fund's name states). Based upon this sample of the top 10 holdings, the fund's average years to maturity is 8.21 versus 7.75 for the index, and its average duration is a reasonable 4.38 years versus 3.50 for the index, respectively.

In terms of return, the fund does have a high coupon of 5.13% and a 30-day SEC yield of 3.52% as of July 31, equivalent to 5.82% for those in the 39.6% bracket. Unfortunately, there are many Industrial Revenue Bonds in the fund. As such, 14.98% of the fund is AMT. Though the fund is susceptible to interest rate changes, the short-term maturity and duration of it does give comfort. The yearly high, $25.80, and low, $24.95, is an extremely narrow band. With interest rates stable since the beginning of the year (and for quite some time) and bad news on municipals behind, this fund will give limited opportunities for capital gains and losses. What it will supply is a high-yield return as a tax-free investment with a short duration.

The final matter to discuss is why is there only $60.37M in this fund at the present time? The easy answer is to state that it is a new fund. Perhaps, but why are other high-yield funds increasing in AUM, i.e. HYD. This week, there was an interesting article on the website In the article, it stated that volatility of ETFs has given the hedge funds an opportunity to make significant short-term profits, to the detriment of the retail investor. "Junk-bond ETFs created for retail investors have been hijacked by hedge funds using them to make broad bets on bond prices, causing roller-coaster distortions in the high-yield market. Funds designed for retail investors have morphed into hedging tools that sell off too suddenly, and in too great a size, for illiquid high-yield bonds to keep up."

The article continued by stating that hedge funds now account for almost 30% of the holdings of junk-bond ETFs, according to research by JPMorgan, more than any other kind of ETF category, except emerging market equity. And that has ended up particularly hurting retail investors, who end up taking a loss well after the fast-money hedge funds have gotten in - and out - of the market.

In general our feeling is, because there is not a lot of "play" or volatility in the short end of this municipal high-yield fund, the institutional funds have stayed away. It may not produce exceptional outsized returns as HYD has done, and is more stable overall due, again, to its short duration and maturity. Based upon this key tenet and our analysis, we feel the SHYD is a very attractive ETF to hold in a stable interest rate market. In a rising interest rate market, there will, of course, be a corresponding correction, but not to the extent of other high-yield ETFs. In a declining interest rate market, we feel capital gains would be limited due to the short-term nature, and defaults may appear, but the fund is well-balanced in sectors to lessen that impact. Overall, the attractive SEC 30-day tax-free return of 3.52% is an appropriate investment for those investors seeking tax-free income in a short-term ETF.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.