Pension funds play a long game. They have traditionally looked to domestic government and provincial bonds as the best match for their liabilities, which extend out for decades. But as rising interest rates threaten to end what’s been a 30-year bond bull market, investors are looking further afield for the best way to make the match.
The threat of rising rates has certainly been a boon for fixed income exchange-traded funds (ETFs)— bond investors want their exposure with a clear escape hatch and ETFs are liquid enough to fit the bill. Consider that bond ETFs have taken in US$32 billion so far this year globally, with institutions like pension funds leading the way—the strongest start to any year since bond ETFs came into the market in 2002.
ETFs have no doubt created broader and more liquid access to a widening spectrum of fixed income products—global, high-yield, corporate and even bonds from China.
But one new area that has been getting some attention are ETFs based on U.S. municipal bonds, which tap into the need for U.S. cities and towns to refurbish and build infrastructure.
Remember that episode of Seinfeld where Kramer lovingly tends his stretch of highway? Municipal bonds are a uniquely American phenomena wherein issuers seek to match up individual money to much-needed care and maintenance of roads, bridges and buildings.
Right now the two biggest municipal ETFs are the iShares AMT-free Muni Bond fund and the Vanguard Long-term Tax-Exempt Fund.
For pension funds, municipal bonds are interesting on a number of levels. They are long-dated like pension liabilities, and the market is large and diverse. The U.S. municipal bond market is currently valued at US$3.6 trillion—a number that’s likely to grow as U.S. cities sport healthier balance sheets.
At the same time, an ETF with multiple holdings adds diversification so problems in one city don’t have as much of an impact across the whole portfolio.
Investors are taking notice—according to Bloomberg, investors have poured $1 billion into ETFs that buy state and local bonds, the fastest start to the year since 2007. The idea is to bring liquid exposure to municipals for investors and add diversification to minimize the impact of problems in a single state or city.
Of course, municipal bonds offer a whole array of tax advantages that international investors might not be able to benefit from—and, of course, they’re listed in the U.S., not Canada.
But for pension funds looking to open up their fixed income exposure and add infrastructure at the same time, the prospect of municipal ETFs is particularly interesting.