Scott Burns: Surveying the municipal bond ETF landscape.
Hi, there. I'm Scott Burns, Morningstar's director of ETF research. Joining me today is Tim Strauts, our fixed-income ETF analyst.
Tim, thanks for joining me.
Timothy Strauts: Thank you.
Burns: So, the municipal market and municipal bond ETFs have seen a lot of volatility lately, a lot of discount activity, but before we start talking about the ETFs, let's just talk about the muni bond market a little bit.
We've seen some negative returns and a lot of volatility. What's been the primary cause of that in the municipal space?
Strauts: The primary reason for the volatility is basically the Nov. 3 Fed meeting, where the Federal Reserve came out and said that they were going to enact a second round of quantitative easing. Well, since that announcement, all fixed income, not just municipals, has basically traded down. The 10-year Treasury went from about 2.6% on Nov. 3 to today about 3.3% ...
Burns: ... On a yield basis ...
Strauts: On a yield basis.
Burns: As yields go up, prices go down.
Strauts: Yes. So the yields have gone up, price has gone down. So that affects munis, too, because munis are priced off of Treasuries. So, most of the move has been because of that. Now, I will say, though, that the municipal bond space was sort of weakening, maybe not really trading down, but just weakening for a month or two before [the announcement]. So on average the muni bond space has traded down further than Treasuries, but mostly it's because of the recent Fed announcement.
Burns: Right, and so we see this increased--almost leverage--on Treasury interest rates for municipal bonds. What's usually the source of that...?
Strauts: What you are going to see is that, typically speaking, in a normal environment, the municipal bond yield should actually be a little bit lower than Treasuries, because you are getting a tax-free yield, assuming you are an individual investor who can get the tax-free benefits. So the yield should be a little bit lower. But recently, actually, the yield has been higher than Treasuries, just because of the increased credit-quality concerns.
Burns: To step away from muni bonds, specifically tax-free muni bonds, let's talk about their cousins, Build America bonds. In the tax package, they did not extend that program this year. What is that going to mean for Build America Bonds and Build America Bond investors, and also for traditional municipal bond investors?
Strauts: Municipal bond investors are going to have a really big impact, because Build America Bonds had taken up about 20% of municipal issuance in the last two years.
Burns: So new issuance and liquidity in the system, right?
Strauts: Yes. So, it had taken up 20% of that new issuance. Now, the municipalities aren't going to be able to go to Build America bonds. So they are going to have to issue tax-free bonds, so the supply is going to increase dramatically in the tax-free space. And given that there are concerns about credit quality, there might even be less demand, so we're going to have an imbalance in supply/demand.
Burns: Right. So we may have this imbalance, we may have a real glut of new issuance with a real shortage of interest?
Burns: Normally what we see with that is that yields pop up, and we see that in returns for investors although with credit quality [concerns].
Strauts: We've already seen that since the tax package was announced and has been passed, we have already seen that for the last couple of Build America Bond issuances, the yields were rising. So people were saying, this is end of the program, yields are going to rise. So, I think the typical investor in Build America Bonds is different than the investor in munis. Build America Bonds are taxable bonds, so the normal investor could be major pension funds…
Burns: Right, corporations…
Strauts: …foreign investors, things like that. Whereas the municipal bonds are typically just retail individual investors, by a large margin.
Burns: All right. So, we talked about some of these credit concerns earlier. A major network news magazine ran a report recently highlighting the significant credit deterioration and budgetary constraints at a lot of municipalities. What's your take right now on the credit quality issue in the municipal space?
Strauts: Well, I do think it's a big issue. As many reports have shown, there are huge deficits at all the state governments; many local governments are having trouble paying their own bills, things like that. So it is a big issue. I think, though, that we're still going to see a small amount of defaults. Even in 2010, there were fewer defaults than in 2009. So it's not like we have seen a lot of defaults.
It's more just the perception of risk, and it doesn't take very much in the municipal bond space to spook investors, because the primary investors, as I said earlier, are the individual retail investors. So if they start seeing news reports about municipal bonds, and especially if it's on major news programs, they get spooked, and they stop buying and they may even start selling. So I would expect a lot of volatility going into next year, and it's probably going to continue most of the year.
Burns: So let's switch to muni bond ETFs. During this sell-off, muni bond ETFs started trading at what we would consider for ETFs pretty significant discounts--3% to 4% range--as the muni bond sell-off and weakening happened.
Why aren't these discounts being arbitraged by the authorized participants, who are mainly investment banks for viewers that don't know. Why isn't this activity happening? Why did these discounts occur, and should investors be concerned?
Strauts: I think it's important to understand that bonds trade differently than stocks. Stocks trade on an exchange, so it's really easy to arbitrage away premiums and discounts, because it's liquid markets on an exchange.
Bonds and especially municipal bonds are traded on an over-the-counter market. So a much less liquid market. There is way more issuance of bonds than stocks. So there are millions of bonds out there. So there is no actual exchange to trade them on. So what you're going to see is that the bonds actually have lower liquidity than the ETFs that track them. …
Burns: So just to be clear: So the ETF holds bonds, and we've got a situation where the bonds are actually less liquid than the actual ETF?
Strauts: The ETF actually can help to create more liquidity for the municipal bonds. But when the municipal bonds are less liquid, it's harder to arbitrage discounts away, because the net asset value that you see on your municipal bond ETF, that's a computer calculation of an estimated fair value.
Well, that computer calculation cannot react as quickly to what the real market is doing. So we're doing some initial research, and our initial findings [indicate] that actually the price of a municipal ETF is a better indicator of the actual value of the underlying portfolio than the actual net asset value that you see in real-time every 15 seconds on the feed.
Burns: And I think that that research is going to have some pretty significant implications not just in the ETF space, but also in the general mutual fund or investing space--that this NAV lag manifests itself actually in the open-end fund, and our initial studies are showing a T+1, I believe, something like that?
Strauts: Yes, so the net asset values are calculated in ETFs and mutual funds generally the same way. So if it affects ETFs, it's going to affect mutual funds. And the difference is in ETFs, the market price can be different than net asset value, but in a mutual fund, you get the net asset value. So it can create some unique arbitrage opportunities there, too.
Burns: So the discount that we see one day becomes an actual lack of discount the next day, but not because the price moved, because the NAV moved.
Strauts: Yes. So there were examples we looked at in the last few weeks where the ETF was maybe down 2% for the day and the net asset value was only down very slightly, and then the next day the price of the ETF was kind of flat, and the NAV dropped 2%, basically showing that the market participants were making better guesses on the true value of the bonds than the actual computer calculation.
Burns: And I think we should always keep things in relative perspective. What do you think the discounts that holders of individual muni bonds were facing? If they were trying to sell individual securities during that period, what kind of spreads were they looking at?
Strauts: Yes, so if you see a 3% spread in an ETF, it's only going to be wider if you actually were a small retail investor trading for an individual portfolio, and when I say small, I mean less than $500,000, less than $1 million trades in bonds.
Burns: Trades, not assets, just the actually trades?
Strauts: Not assets. I have $500,000 of one bond. I want to trade that. So yes, the spreads should probably be wider.
Burns: Well, Tim, thanks for your insights on the municipal bond space and muni ETFs.
Strauts: Thank you.
Burns: I am Scott Burns with Morningstar. For this and other information, please check out Morningstar's ETF Center on Morningstar.com and Morningstar's ETFInvestor newsletter.