ETFs claim more of the muni market

Federal Reserve data shows Muni ETFs held $80 billion as of the end of the third quarter, down from less than $50 billion two years ago. Citigroup’s projects will be worth $125 billion by December 2022.

This year investors spent record amounts of cash buying shares in all kinds of ETFs, baskets of securities that trade as easily as stocks and typically track indexes. They are drawn to muni ETFs for easy access to tax-free yields at low costs under flexible trading conditions, especially with concerns about new taxes under the Democratic administration. ETF sponsors such as BlackRock Inc. report that muni ETFs have helped bring cash and fee revenue to the client.

But trying to track prices in real time can be difficult in a market where nearly 50,000 state and local governments sell debt and some bonds go years without changing hands.

The ETF’s spread is part of an ongoing shift to the nearly $4 trillion municipal market, where the typical investor purchased individual bonds once and deducted coupons until maturity. For decades, retail investors have been turning to mutual funds, which they can trade once a day at closing prices.

ETFs allow investors to watch price fluctuations in real time and trade as often as they want, an attractive feature for working-from-home investors accustomed to watching meme-stock drama in the corner of their screen. Huh.

“New investors tend to be more comfortable with the ETF structure,” said Steve Lappley, US head of bond ETFs at BlackRock Inc., which controls $36 billion in muni bond ETFs. “It’s a desire for transparency and agility in business.”

As a group, muni ETFs charge a percentage point less than open-ended muni bond mutual funds — about a quarter — as a share of assets, according to a weighted average calculated by Morningstar Direct. The difference is 0.03 percentage points for a passive fund that tracks the index. Through November on investment-grade muni ETFs and mutual funds, post-fee yields were roughly the same.

Paul Winters, investment advisor at Five Seasons Financial Planning in Salt Lake City, Utah, holds nearly $3 million in municipal debt managed in passive ETFs, after shifting his clients from mutual funds over the past decade. He added that he appreciates not having to worry after trading that a late-breaking headline will affect the share price.

“When you enter the order you know what the price is going to be,” Mr. Winter said, adding that the momentum helps them to bargain in equities or commodities.

Mentors aren’t just fans. “There’s certainly been good adoption on our platform by individual adopters,” said Rich Powers, head of ETFs and index product management at Vanguard Group.

But while muni ETFs trade like stocks, the underlying bonds do not, a reality that can contribute to losses during market turmoil.

Since many munis trade frequently, valuation services parse through trading data and estimate bond values. In normal times, ETF share prices and the estimated value of the underlying bond move in lockstep as financial firms take advantage of any mismatch by buying falling shares, exchanging them with an ETF sponsor for the underlying bonds, and selling those bonds. Huh.

But during March 2020, during the liquidity crisis triggered by the COVID-19 pandemic, many firms opted not to sell the underlying bonds. According to a study by the Municipal Securities Rulemaking Board, the muni bond industry’s self-regulatory organization, fewer data points were available to help calculate valuations.

For more than a week, share prices of the investment grade municipal bond ETF, run by BlackRock and Vanguard, outperformed the estimated value of the underlying bond, according to Refinitiv data. In the VanEck ETF that tracks the less liquid high-yield municipal market, the gap lasted more than two months.

“If you’ve bought (during that period) I think it’s good,” said Simon Wu, MSRB’s chief economist. “If you sold I guess it’s no good.” Conversely, investors who bought or sold shares of Muni Mutual Fund during that time received higher prices based on valuation service estimates.

Mr Powers said the episode shows that ETFs can recover quickly even under intense pressure. “Fixed-income ETFs stand up to the test,” he said. Jim Colby, senior portfolio manager at Van Eck, said high-yield ETFs have generally tracked predictable value since last summer.

Yet the episode helped Erin Hydari, a financial advisor at Denver-based Moneta Group, guide clients interested in Munis into mutual funds.

“I think bond ETFs or investment grade corporate bonds are fine for governments,” Ms Hydari said. “I worry in the municipal space if there is enough liquidity.