Amid Dearth Of Supply, Enthusiasm For Muni ETFs Remains

Some market observers might be apt to say there is plenty of supply in the municipal bond market, but some would contest that point, noting the lack of municipal bond supply has forced yields lower and the yield curve to flatten.

Those factors are not damping demand for exchange-traded funds such as the VanEck Vectors High-Yield Municipal Index ETF (Market Vectors ETF Trust (NYSE:HYD)) and the VanEck Vectors AMT-Free Intermediate Municipal Index ETF (Market Vectors-Inter. Muni. Index (ETF) (NYSE:ITM)). Investors have also put more modest amounts of new money to work YD's short duration cousin, the VanEck Vectors Short High-Yield Municipal Index ETF (Market Vectors ETF Trust (NYSE:SHYD)).

Supply And Demand

But why the lack of supply? Supply is commonly defined as new issuance to finance public purpose projects around the country. Issuance itself is subject to a number of factors, not least of which is predictable seasonality. Generally speaking, at the end of the second quarter issuance tends to intensify as municipalities approach their fiscal year ends, predominantly at the end of June.

In July and August, there is a natural lull as people take vacations and the market receives less attention. Finally, in the last quarter of the year, the pace of issuance generally picks up again as bankers seek to book deals before the year ends, according to a recent VanEck note.

The Role Of Interest Rates

Municipal ETFs have been popular destinations this year as investors have continued hunting for a yield, a search that has stoked interest in longer duration fare as the Federal Reserve has consistently put off raising interest rates.

With the interest rate environment still benign, income investors may want to consider an ETF like HYD, which has an effective duration of 8.3 years. HYD's performance has also been impressive when considering there were some concerns about the possible effects of low oil prices on municipal bonds issued by major oil-producing states. The ETF holds nearly 1,380 bonds, but its largest weight to a big oil state is 7.3 percent to Texas, but that is just the fund's fourth-largest state allocation.

Demand for munis, by contrast, has remained robust. We entered 2016 coming off the back of two strong years in 2014 and 2015, and investors comfortable with, if not reliant upon, steady income from the muni space. And in the face of persistent uncertainty in both the domestic U.S. and international markets, munis have continued to provide investors with low correlation to other asset classes, and strong credit quality, in addition to positive performance for the past three years according to the Barclays muni bond indices, added VanEck.

HYD has added over $265 million in new money year-to-date while investors have poured $109.5 million into ITM.