4 Reasons Why Muni Bond ETFs Are Back In Favor

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Includes: ITM, MLN, MUB, XMPT
by: Zacks Funds

It seems that the difficult days of muni bond investing are over, at least for the coming few days. As we all know, municipal bonds are excellent choices for investors seeking a steady stream of tax-free income.

But with President Trump pledging for lower personal income tax rates, investors' desire for a tax shelter in munis was initially quelled. Paul Ryan, the speaker of the House of Representatives, in fact pledged to lower the top tax bracket from 43.4% to 16.5%, as per the Financial Times.

If enacted, the tax cuts would simply replace the need for muni bond investing with taxable Treasuries or corporate bonds. Plus, Trump had proposed to increase infrastructure spending. If this happens, munis will be forced to issue more bonds offering higher yields amid lowering demand.

As a result, the fervor for muni bond investing backtracked after Trump's win in November. The iShares National Muni Bond ETF (NYSEARCA:MUB) was down about 1.6% in the last six months (as of April 13, 2017). In the time frame starting from the election to the end of 2016, investors pulled out over $14 billion from their portfolio, as per FPFR data.

However, the space bounced back lately. MUB advanced over 1.7% in the last one month (as of April 13, 2017). If this is not enough, municipal bond funds registered $1.6 billion inflows in the week ended April 12, marking the third biggest weekly inflow on record, according to flows tracked by EPFR.

Below we highlight the reasons for this renewed enthusiasm in muni bond investing.

Hopes of a Tax Cut Fading

Trump trade seems to have lost some steam on the president's inability to pull off the Health Care bill. This has raised questions on the materialization of his other promises, like higher infrastructure spending, deregulation and tax cuts. In fact, it is too early to factor in the tax cut prospects in muni ETF investing.

Decline in Treasury Yield

Notably, safe haven trade like U.S. Treasury bond investing prevailed in the market on geopolitical concerns. Investors should also note that the yield on the 10-year Treasury note has slid 38 bps to 2.24% as on April 13, 2017, from this year's high of 2.62% hit in mid-March. The Fed's dovish guidance on policy tightening in the March meeting was also responsible for this trend.

This should perk up demand for muni bonds, which are safer than corporate bonds and yield higher than Treasuries. According to Moody's Investors Service, the 1970 through 2015 average cumulative 10-year default rate for all rated munis was only 0.15%.

Looming Tax Day

Americans are looking for ways to lower their tax burden ahead of Tax Day on April 18. In this vein, muni bond ETF investing comes across as a lucrative bet.

Historically Munis Less Sensitive to Tax Changes

Citigroup also believes that historically (since 1980), retail demand for munis has shown lower sensitivity to changes in the marginal tax rate. Though we may see a reduction in the marginal federal tax rate from 39.6% to 33%, the average tax bracket of 25% for all individual holders of municipal bonds are less likely to change much, as per the source.

One-Month Scorecard of Muni ETFs

In the last four weeks (as of April 13, 2017), several muni bond ETFs were in fine fettle. The VanEck Vectors CEF Municipal Income ETF (NYSEARCA:XMPT), which yields about 5.20%, added about 4.8% in last one month (as of April 13, 2017) against 5.5% gains in the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), which yields about 2.5%.

VanEck Vectors AMT-Free Long Municipal Index ETF (NYSEARCA:MLN) tracks the overall performance of the U.S. dollar-denominated, long-term, tax-exempt bond market with an upper medium credit quality. It yields about 3.07% and added about 2.4% in the last one month.

VanEck Vectors AMT-Free Interm Muni ETF (NYSEARCA:ITM), which tracks the overall performance of the U.S. dollar-denominated, intermediate-term, tax-exempt bond, advanced 2.5% in the last one month. It yields about 2.22% annually.

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