Muni funds take on water as rates rise

Long durations, low credit quality spell trouble

Dec 5, 2016 @ 1:04 pm

By John Waggoner

Municipal bond funds are starting to sink as interest rates rise.

The yield on the benchmark 10-year Treasury note has soared from a low of 1.37% July 8 to 2.40% Monday, sending bond prices plummeting. Municipal bond funds, whose interest is generally free from federal taxes, haven't been exempt from the pain. Investors — largely steered by advisers — have poured an estimated $61.4 billion into muni funds the past 12 months, according to Morningstar.

Funds that invest in long-term bonds with the shakiest credit have been hit hardest. Long-term California munis, for example, are down 6.6%, including reinvested interest, since the July low in interest rates. High-yield munis are down 6.1% the same period.

"What have sold off are the riskier strategies," said Todd Rosenbluth, director of ETF and mutual fund research at CFRA. "Basically, that's the nature of muni bonds,"

Conversely, funds that buy short-term, high-quality paper have fared the best. Short-term muni funds have fallen an average 1.85% since the July low in rates.

Two bright notes: The carnage in the worst muni funds hasn't been as extensive as the losses in the worst taxable funds. The worst muni fund to date is Nuveen California High Yield Municipal Bond (NCHRX), an $800 million long-term fund that has shed 9.71% since rates started rising. The institutional fund charges 0.65% in expenses and has an average effective duration of 10.56 years, Morningstar says. Average credit quality: BB.

In contrast, Vanguard Extended Duration Treasury Index (VEDTX), a $1.1 billion fund, has plunged $21.2% since July 8. While the fund invests in high-quality Treasury securities and charges just 0.06% in expenses, its average duration is 24.73 years.

Results for munis were similar in the exchange-traded universe. The top performer was PowerShares VRDO Tax-Free Weekly ETF (PVI), which has gained 0.14% since rates bottomed in July. The $58.6 million fund yields 0.56%, charges 0.25% in expenses and invests primarily in variable-rate demand obligations, which minimizes interest-rate risk.

The worst muni ETF in this cycle: VanEck Vectors CEF Municipal Income (XMPT), down 12.63%. The $87.2 million ETF invests in closed-end muni funds and has a 1.52% expense ratio.

Retail investors, who dominate the municipal bond fund market, tend to focus more on tax-free income rather than total return. "Relative stability is particular appealing for these folks," Mr. Rosenbluth said.

How long will the selloff go on? Chris Alwine, principal and head of Vanguard's municipal bond group, thinks that the current level of rates discounts much of the future economic growth (and inflationary pressure) from the incoming Trump administration. "The bond market is factoring in a decent improvement in growth and a fairly aggressive Federal Reserve," Mr. Alwine said. "It has gotten a little ahead of itself."

How the largest municipal bond categories have fared since the low in interest rates on July 8
Fund categorySince rate low*2016**
US OE Muni California Long-6.57%-1.38%
US OE High Yield Muni-6.1%-0.31%
US OE Muni National Long-5.75%-1.24%
US OE Muni California Intermediate-5.62%-1.84%
US OE Muni New York Long-5.45%-0.67%
US OE Muni New Jersey-5.26%-0.55%
US OE Muni New York Intermediate-5.21%-1.49%
US OE Muni Massachusetts-5.1%-1.26%
US OE Muni Ohio-5.05%-0.86%
US OE Muni National Interm-5%-1.3%
US OE Muni Pennsylvania-4.97%-0.76%
US OE Muni Minnesota-4.93%-1.3%
US OE Muni Single State Interm-4.81%-1.36%
US OE Muni Single State Long-4.7%-0.51%
US OE Muni Single State Short-2.65%-0.64%
US OE Muni National Short-1.85%-0.56%
Dividends, gains reinvested. Source: Morningstar.
Note: *7/8/2016-12/2/2016; **1/1/2016-12/2/2016
How the largest municipal bond funds have fared over the same period
Fund TickerMorningstar CategoryFund Size ($ billions)Since low in rates2016
Vanguard Interm-Term Tx-Ex InvVWITXMuni National Interm$50.6-4.91%-1.13%
Vanguard Ltd-Term Tx-ExVMLTXMuni National Short$23.3-2.11%-0.64%
Franklin CA Tax-Free Income AFKTFXMuni California Long$16.6-7.1%-0.84%
Vanguard Short-Term Tx-ExVWSTXMuni National Short$13.8-0.57%0.16%
American Funds Tax-Exempt Bond AAFTEXMuni National Interm$13.2-5.16%-0.92%
Nuveen High Yield Municipal Bond INHMRXHigh Yield Muni$12-7.78%-0.31%
Vanguard CA Interm-Term Tax-Exempt InvVCAIXMuni California Intermediate$11.4-5.44%-1.58%
Franklin Federal Tax-Free Income AFKTIXMuni National Long$11.2-4.33%-0.14%
Vanguard High-Yield Tax-ExemptVWAHXMuni National Interm$10.5-6.36%-0.64%
Vanguard Long-Term Tax-ExemptVWLTXMuni National Long$9.6-6.39%-1.11%
Franklin High Yield Tax-Free Inc AFRHIXHigh Yield Muni$8.5-5.57%0.21%
Thornburg Limited-Term Muni ALTMFXMuni National Short$7.6-3.41%-1.36%
Invesco High Yield Muni AACTHXHigh Yield Muni$7.3-6.32%0.15%
AB Diversified MunicipalSNDPXMuni National Short$6.7-3.71%-0.97%
BlackRock National Municipal InstlMANLXMuni National Interm$6.4-4.63%-1.05%
Fidelity® Interm Muni IncFLTMXMuni National Interm$6-4.45%-0.91%
Wells Fargo Short-Term Municipal Bd CWSSCXMuni National Short$5.5-1.55%-1.04%
Oppenheimer Rochester® Fund Municipals ARMUNXMuni New York Long$5.5-3.12%5.01%
Wells Fargo Ultra Shrt-Term Muni IncInstSMAIXMuni National Short$5.5-0.4%0.07%
Fidelity® Municipal IncomeFHIGXMuni National Long$5.4-6.21%-1.2%
Deutsche Managed Municipal Bond SSCMBXMuni National Long$5.3-5.84%-1.38%
Nuveen Intermediate Duration Muni Bd INUVBXMuni National Interm$5.2-5.8%-1.68%
Franklin NY Tax-Free Income AFNYTXMuni New York Long$5.1-3.35%0.16%
Oppenheimer Rochester® High Yld Muni BORNBXHigh Yield Muni$5.1-5.01%3.14%
BlackRock Strategic Muni Opps InstlMAMTXMuni National Interm$4.8-5.51%-0.98%
Dividends, gains reinvested. Source: Morningstar.

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