The following post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga.
All things considered, the municipal bond market had an exceptional 2020.
In a year in which municipalities were faced with an economic crisis that had some investors concerned about defaults, the VanEck Vectors CEF Municipal Income ETF XMPT rose 3.44% in 20201, a stunning turnaround given its sharp decline during March (click here, to view the fund’s standardized performance).
Muni bond investors have several tailwinds to thank for that rebound, according to VanEck Senior ETF Product Manager Michael Cohick: a supply-demand imbalance driven by fewer bond issuances, the realization that municipalities are in a better position than the financial crisis of 2008, and the Federal Reserve, whose municipal liquidity facility acted as a lender of last resort.
“Although only used by two issuers, simply the fact that the municipal lending facility was put in place brought tremendous calm and reassurance to the market,” he said. “We also saw that municipalities, state and local governments, were in a much better position in terms of fiscal health and reserve funds than they were in 2008 to allow them to weather the storm. So I think these provided a backstop to the market.”
Source: St. Louis Fed2
The 2021 Outlook
Going forward, Cohick believes demand for muni bonds will continue to rise as investors search for yield in light of historically low U.S. Treasury rates, a falling dollar, and increased fears of rising inflation.
There’s also the political environment to consider. A Biden administration and Democrat-controlled Congress are likely to unwind some Trump tax cuts. Anticipation of this is already creating investor demand for muni bonds for their tax-exempt qualities.
Unlike other fixed income assets, municipal bonds have one key tax advantage: the interest generated from the bonds is exempt from federal income taxes. As a result, some investors may seek out municipal bond exposure to shield themselves from higher tax rates.
“There's anticipation for higher taxes, which is going to potentially lead to very strong demand for tax-exempt paper from investors across the board,” Cohick said. “Broadly speaking, the yield environment that we find ourselves in is making investors search for attractive pockets of the market to add income to their portfolios.”
Gaining Exposure To Muni Bonds
Many investors looking for municipal bond exposure will do so via a mutual fund or ETF, such as XMPT, which allows them to broadly diversify across states, sectors, quality, and asset class.
Unlike most typical broad-based muni bond funds however, XMPT is structured as an ETF that holds municipal bond closed-end funds, or “CEFs."
The closed-end structure of XMPT’s underlying holdings allows those fund managers to effectively use leverage, meaning they borrow at low rates in the short end of the marketplace and buy long-dated municipal bonds with higher yields.
Also, because CEFs have a set number of shares, they cannot rely on the creation-redemption mechanism of ETFs that generally acts to keep a fund’s share price close to its net asset value (NAV). As a result, closed end funds have a tendency to trade with wide discounts to their net asset value.
In other words, the closed-end fund nature of XMPT gives it the potential to offer investors attractive income from a high-quality portfolio.
“Both leverage and systematic approach to buying assets at a discount create a yield advantage,” Cohick said. “The rules governing XMPT’s index provide a systematic way to invest in CEFs exactly how professionals do: buying municipal closed-end funds trading at wider discounts and selling funds trading at higher premiums.”
The chart below shows the taxable-equivalent yield of XMPT, against the 7-year, 10-year, 20-year, and 30-year U.S. treasury nominal or pre-tax yields. You can see how the yield from XMPT is greater than the benchmarks. This is due to the underlying holdings being closed-end funds.
Source: U.S. Department of Treasury, VanEck. As of 12/31/2020
1. VanEck data
The preceding post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga. Although the piece is not and should not be construed as editorial content, the sponsored content team works to ensure that any and all information contained within is true and accurate to the best of their knowledge and research. This content is for informational purposes only and not intended to be investing advice.
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