Largest muni ETF's premium grows as fund exodus abates

The shift to a premium for muni ETFs points to a potential return to earnings

Jan 14, 2014 @ 9:48 am

The biggest exchange-traded fund tracking the $3.7 trillion municipal bond market is selling at the highest premium to the value of its assets since May, an early sign that local debt may avoid a second year of losses.

After the worst year since 2008 for city and state debt, the shift to a premium for muni ETFs points to a potential return to earnings, said Mikhail Foux, a credit analyst at Citigroup Inc. Local securities may earn 4% to 6% in 2014, he said.

The $3.1 billion iShares National AMT-Free Muni Bond ETF sold at 0.28% more than the worth of its holdings as of Jan. 10, the highest since May, data compiled by Bloomberg show. The fund is mirroring the broader tax-exempt market as investors are pushing yields down from a three-month high set in December, said Bart Mosley, co-president of Trident Municipal Research.

“Historically, it's a precursor of abating outflows and stronger performance of munis,” Foux said of the swing to a premium. “We continue to be somewhat bullish on munis.”

Citigroup's forecast underscores Wall Street banks' varying 2014 outlooks for the market, which states and municipalities nationwide use to pay for schools, bridges and roads.

2014 PROSPECTS

Morgan Stanley's main forecast for this year calls for returns ranging from a loss of as much as 3.8% to a 0.2% gain as an improving economy leads the Federal Reserve to trim its bond-buying program, pushing up interest rates, the bank said in a Jan. 7 report.

Tax-exempt securities lost 2.9% last year, Bank of America Merrill Lynch data show. The last time munis posted two straight annual losses was 1980-81, according to Barclays PLC data.

Created in 2007, MUB is an exchange-traded fund. ETFs are similar to mutual funds that track indexes of equities, bonds or commodities. Yet they can be bought and sold during the trading day and their prices may rise or fall more than the value of the assets they hold.

Demand has revived as munis are rallying this month and as a months-long cash exodus from muni mutual funds is slowing. Benchmark 10-year munis yield 2.74%, down from as high as 3.05% last month, Bloomberg data show. The rate reached 1.52% in December 2012, the lowest since at least January 2009.

“People have been trained to think of interest rates just being too low,” said Mosley at Trident. “And that's just not true anymore.”

Mosley estimates that MUB will earn in 2014 what the fund's bonds yield on average, which is 3.04%, Bloomberg data show.

As individual investors return to munis, they can benefit from potential yield swings resulting from reduced holdings by Wall Street brokers and dealers, said George Friedlander, chief municipal strategist at Citigroup.

The companies, the municipal market's middlemen, held $18 billion of munis as of Sept. 30, the least since June 2002, according to Federal Reserve data.

“With a relatively thin and volatile market, there will be entry points for investors,” Mr. Friedlander said.

The latest fund data shows individuals, who own about 60% of the market either directly or through mutual funds, are growing more bullish.

Investors pulled about $19 million from U.S. muni mutual funds last week, the least since withdrawals began in May, according to Lipper U.S. Fund Flows data.

“There's still room for some more outflows, but ultimately we'll get close to stable or zero,” Mr. Friedlander said.

Meanwhile, in the market for local debt, issuers have scheduled about $7.4 billion of sales in the next 30 days, Bloomberg data show. The tally is below the one-year average of $9.2 billion, marking an issuance lull that is helping drive up investors' appetite for tax-free bonds.

The benchmark 10-year muni yield compares with 2.83% on similar-maturity Treasuries.

The ratio of the interest rates, a measure of relative value, is about 97%, close to the lowest since May, compared with a five-year average of 99%. The lower the figure, the more expensive munis are compared with federal securities.

(Bloomberg News)

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