Looking For Income? Try High-Yield Muni ETFs

Includes: HYD, HYMB
by: Zacks Investment Research

By Eric Dutram

Although the economy continues to marginally improve, yields are still ultra low across the curve. 10 Year Treasury bonds still pay out about 2% a year, forcing many to seek payouts in the stock market instead. Beyond this strategy, high yield securities in the bond world are also a popular option although these securities obviously have risks of their own as well.

Junk corporate bonds often have higher default rates than their investment grade counterparts forcing them to pay out more to investors in order to entice a purchase in this asset class. Yet with default rates still pretty low across the board, cycling into this market has become a crowded trade as junk bond ETFs are among the most popular funds in the world in terms of AUM growth in the past few months. Fortunately for investors, there is still a high yield market that can offer strong payouts but has not seen quite the level of interest from the retail space, the muni bond market.

High yield securities in this asset class are often overlooked in favor of their more famous brethren in the taxable market. This is likely due to the smaller size of the high yield muni space as well as general reservations over state and local budgets given the ongoing economic issues. This is especially the case after dire predictions from analysts such as Meredith Whitney who called for hundreds of billions of dollars in defaults in the muni space (read The Forgotten Municipal Bond ETFs).

Yet, Whitney’s prediction was from December of 2010, and since then, the muni bond market has survived relatively intact. While this isn’t to say that we won’t see a muni apocalypse down the line, the odds of such a disaster have to be dropping quickly. After all, with a modestly improved economy, tax collections are likely to be on the rise helping to improve budget situations across the country. If this continues, it could help to stave off turmoil in the muni market and keep default rates low across the board.

As a result, it could be time to cycle into this high yielding space for exposure, especially for investors seeking better yields. Default rates look to be low if the economy remains on track while the space has failed to attract the same level of interest as corporate bonds, suggesting that better values may be in the sector. So for investors intrigued by this thesis, a closer look at either of the two high yield muni bond ETFs, which we have highlighted below, could be in order:

Market Vectors High-Yield Muni ETF (HYD)

This ETF follows the Barclays Capital Municipal Custom High Yield Composite Index which tracks a variety of municipal bonds from across the country. The product looks to put 75% in non-investment grade munis while allocating about 25% to Baa/BBB rated securities as well. The fund charges investors 35 basis points a year in fees and debuted in February of 2009 giving it a track record of about two years. In that time, the fund has built up a sizable following, amassing over $450 million in assets while seeing volume of about 140,000 shares a day (read Forget About Low Rates With These Bond ETFs).

In terms of holdings, the fund has a heavy focus on health care (41.7%) and industrial revenue (28.3%) bonds which comprise the lion’s share of the assets. State exposure is also pretty spread out as California bonds comprise about 18.3% of the fund while New York bonds are another 11.1%. Beyond these two, the rest of the top five is rounded out by the territory of Puerto Rico (8.5%), and then the states of New Jersey (7.6%) and Ohio (6.9%). Maturity levels are tilted towards the longer end of the curve giving the fund a greater focus on yield but also on interest rate risk as well. Thanks to this, the fund pays out a 30 Day SEC Yield of 5.55%, a level that transfers over to 8.5% in tax equivalent terms for those in the top tax bracket.

SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB)

The newest entrant in the high yield muni space is State Street’s HYMB, a fund that tracks securities rated ‘junk’ that are issued by municipalities across the nation. Bonds that are included also must be dollar denominated, fixed rate, and be exempt from regular federal income taxes as well. Currently, securities rated below Baa comprise a plurality of the assets at about 44% of the fund while NR and Baa rated securities make up 23.2% and 20.4%, respectively. Despite the fund’s youth and expense ratio of 45 basis points, it has seen solid inflows so far in its history, amassing about $60 million in AUM although it trades just about 14,000 shares a day (see Inside The Closed-End Fund ETF).

For holdings, California and Florida muni bonds make up about 25% of the portfolio, while securities from New York, Illinois, and Colorado, round out the top five and make up another 24% of the fund. This product is also skewed towards securities at the end of the curve, as bonds that mature in less than 15 years account for just under 20% of the total. However, thanks to the higher focus of this fund on better rated securities, as well as the lower average years to maturity, HYMB has a lower yield. Yet, the payout is still pretty good as it comes in at 5.1% in 30 Day SEC Yield terms, or 7.9% in tax equivalent levels for those in the highest bracket.