As I have discussed before, the fixed income ETF industry has taken off in the past few years, with new investors discovering the funds every day. This has generated a lot of attention and many good questions as investors dig into this new asset class to figure out how it works and how best to use it. And as with any new instrument, there are some in the market who don’t yet fully understand how fixed income ETFs work.
A recent article published by a well-known news source nicely captures both the highs and lows of bringing a new product to market; the praise for the quality of what we are doing, along with the misconceptions about the fund mechanics. While this piece does mention flattering things about MUB (iShares S&P National AMT-Free Municipal Bond Fund), it notes that MUB is trading at a price above its NAV (a “premium”) and recommends that investors sell MUB and buy another fund instead.
Unfortunately, almost before the ink on the article was dry the premium flattened and the “trade” had already disappeared. But this isn’t the first time we’ve encountered this situation, and it likely won’t be the last. There are a few reasons why the logic here is flawed – the first is that it reflects a lack of understanding about how fixed income ETFs trade.
So what happened in this case? MUB’s price premium to its NAV reflects market supply and demand for municipal bond exposure. For the last couple of weeks there has been a scarcity of new municipal bond supply, which led investors to bid up the price of the muni exposure that they could buy, which led to MUB’s price premium. MUB reflected the actionable price of muni bonds in the market. And as supply and demand forces shift, bond prices and fixed income ETF premiums can move quickly.
This week we saw municipal bond supply start to reappear with $6 billion in new issuance. This new issuance helped balance supply and demand in the muni market, and on Wednesday MUB’s premium declined.
But in addition to the perils of chasing a fleeting premium, when you look at the trade more closely you see that it doesn’t consider a number of realities that an investor would face if they tried to execute. Specifically:
- An investor would incur transaction costs in putting on and then reversing the trade. We estimate that round trip costs would be 32 basis points. (Source: Bloomberg, based on spreads of MUB and TFI as of 2/23/2011).
- The trade may result in a capital gain if the holder has seen MUB appreciate. The impact could be substantial given how well muni bonds have performed over the past year. Say an investor bought MUB on 12/31/2011 at $108.25, and then sold it at the 2/22/2012 closing price of $113.77. The apparent gain of $5.52 would be subject to short term capital gains taxes of approximately $1.55. Capital gains tend to be an especially sensitive issue for investors who are looking to municipal bonds for their tax efficiency. (Capital gains tax rate assumed to be 28%).
- An investor would incur commissions and ticket charges as they would on any exchange transaction (the amount varies by custodian).
Depending on when an investor acquired MUB, these costs could outweigh any apparent gain from selling MUB at a premium.
Can fixed income ETFs be used to take advantage of tactical opportunities? Absolutely, and many investors use them to do so. But before putting on any trade, even one recommended by purported experts, think hard about what you are ultimately trying to accomplish with your investment. Consider the suitability of an opportunity, for many investors municipal bonds represent a strategic rather than tactical investment. And of course take into account all of the costs that would be incurred in a trade.
I expect that as the fixed income ETF market continues to grow that investors and market participants will gain a deeper understanding of the fund mechanics and trading behavior. Hopefully then more conversations can focus on what is really important to investors, building better investment portfolios.
The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data for iShares Funds current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.
For standardized MUB performance, please click here.
For standardized TFI performance, please click here.
Investment comparisons are for illustrative purposes only and are not meant to be all-inclusive. To better understand the similarities and differences between investments, including investment objectives, risks, fees and expenses, it is important to read the products’ prospectuses.
The MUB capital gains example is strictly for illustrative purposes and does not represent any actual investment outcome.
Bonds and bond funds will decrease in value as interest rates rise. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Federal or state changes in income or alternative minimum tax rates or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value.
Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. ETFs are obliged to distribute portfolio gains to shareholders.
