Cash is pouring into municipal bond ETFs. Here's why they could be winners for investors

Published Sun, Jul 10 20227:28 AM EDT

Jesse Pound @/in/jesse-pound @jesserpound

Municipal bond funds may be having their moment in the sun after a rough start to the year for fixed income. According to Strategas Research, the iShares National Muni Bond ETF (MUB) saw the second highest inflows in the second quarter among U.S. ETFs at $5.4 billion. That was behind only the SPDR Bloomberg 1-3 month T-bill ETF (BIL) , which tracks short-term Treasuries. That has continued in the early days of the third quarter, with the iShares fund picking up another $106.7 million of inflows last week, according to FactSet. Inflows are not a perfect measure of investor demand, but the overall trend seems to be toward more conservative areas like municipal bonds, according to Strategas strategist Todd Sohn. "Sector flows skewed decisively defensive with Healthcare and Staples scoring the largest inflows (roughly +$15 Bn combined), while economically sensitive Financials and Discretionary saw sharp outflows (-$20 combined). … The surge in cash-like bond flows echoes this, with the category collecting a massive +$32 Bn in 1H. Higher short-term rates are an additional boost," Sohn wrote. The renewed interest in the fund came after a rough start to the year. Bond prices move inversely to yields, which spiked in the first half as the Federal Reserve began to reverse its pandemic-era policies. The iShares National Muni Bond ETF is down more than 8% year to date. The Vanguard Tax-Exempt Bond Index Fund ETF (VTEB) , which has added more than $1 billion of inflows over the past month, is similarly down 8.6% for the year. "It did feel as though at times in the first half of the year that there was forced selling happening in certain parts of the credit markets, and I would say that municipals ... were one of the sectors that just seemed as though there was a pretty relentless amount of selling," said Mark Heppenstall, chief investment officer at Penn Mutual Asset Management. A more upbeat second half? There are some reasons to think that the second half of the year could be better for municipals. For one thing, the 10-year Treasury yield is now well below its highs of the year, even after some big intraday jumps late last week. "Rising interest rates should also pose less of a headwind to performance because we believe the bulk of the move up in yields this year is likely behind us," Cooper Howard, a fixed income strategist at Charles Schwab, said in a note. Municipal bonds may be unlikely to see big gains in price that can be found in assets like growth stocks, but their tax advantages versus private debt can help boost the payouts for income-hungry investors. The interest paid on municipal bonds by governments is not subject to federal income tax. The iShares fund's payout over the past 12 months has been about 1.9%, but it has had larger payouts during periods when interest rates were higher. As new bond issuances are added to the fund's portfolio, the payout could rise. As yields have jumped this year, and concerns about an economic slowdown have widened spreads, high quality debt that is slightly riskier than Treasurys could be a sweet spot for investors. "The municipal side and the high-quality corporate side would both be more attractive at this point than Treasurys," Heppenstall said. That is especially true for longer-term bonds, according to Schwab's Howard. "Longer-term munis are more attractive than short-term munis. Yields relative to Treasuries are more attractive for longer-term munis compared to short-term munis," Howard said. The two main ETFs offer relatively cheap and simple ways to get exposure to the market. The iShares fund and the Vanguard fund, which pay out on a monthly basis, have expense ratios of less than 0.1%. There are several other municipal bond ETFs with significant assets, including offerings from Nuveen and Invesco.