HYD: A Rare Opportunity In This Municipal Bond ETF

June 24th, 2013 by

high yield bond etfLast week’s post-FOMC-statement selling brought with it some notable dislocations in the world of ETFs.  One ETF in particular, the Market Vectors High-Yield Municipal Index ETF (HYD), closed the week at a 5.65% discount to net-asset value, its second largest closing discount ever.  The largest ever closing discount occurred on August 8, 2011 at 6.74%.

 

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As the table below illustrates, HYD has been trading at a discount to its NAV since May 31, and after the Fed’s FOMC statement last Wednesday, the discount widened significantly.

Date

% Premium/Discount

6/21/2013

-5.65%

6/20/2013

-4.53%

6/19/2013

-3.15%

6/18/2013

-1.37%

6/17/2013

-1.46%

6/14/2013

-2.11%

6/13/2013

-2.80%

6/12/2013

-3.27%

6/11/2013

-3.63%

6/10/2013

-2.70%

6/7/2013

-2.08%

6/6/2013

-1.95%

6/5/2013

-3.23%

6/4/2013

-2.25%

6/3/2013

-0.52%

5/31/2013

-0.12%

5/30/2013

0.33%

Source: Vaneck.com

In August 2011, after reaching a discount to NAV of more than 6%, two-thirds of that discount disappeared in just two trading days.  While I don’t know if the current discount to NAV will narrow as quickly as it did in 2011, I do suspect that the current opportunity to purchase HYD at a significant discount to its NAV will be brief.  For those investors interested in taking advantage of this rare opportunity, I would like to provide some important background information on this fund.  Later in the week, I will go into more details on tax considerations associated with dividends paid by HYD.

The Market Vectors High-Yield Municipal Index ETF tracks the Barclays Municipal Custom High Yield Composite Index.  The Barclays index that HYD tracks has a 75% weighting to non-investment grade municipal bonds and a 25% weighting to triple-B-rated investment grade municipal bonds.  If you have been on VanEck’s HYD page, you may have noticed that HYD’s holdings appear not to have a ratings breakdown that matches the Barclays index it tracks.  After all, just 14.94% of HYD’s net assets, not 25%, are listed as triple-B-rated bonds.  Moreover, 19.36% of HYD’s net assets are in double-B-rated bonds, and 17.45% are in single-B-rated bonds.  To make matters worse, a whopping 46.43% of net assets are in bonds labeled as “Not rated.”  Over the years, I’ve found it quite valuable to read the fine print when purchasing goods and services.  In the world of financial securities, it also pays to look beyond headlines.  Regarding HYD’s large “Not rated” component of the portfolio, it is important to note that Market Vectors defines “Not rated” as a security rated by fewer than two of the following four rating agencies: Moody’s, S&P, Fitch, and DBRS.  While we can’t say for sure, it is reasonable to believe that HYD is tracking its index according to the credit rating standards, even if that means some of its holdings are only rated by one credit rating agency.

Other information of interest include the following: HYD currently has a market cap just shy of $1 billion, a net expense ratio of 0.35%, a 30-day SEC yield of 5.01%, and 325 holdings in its portfolio.  Of the 325 holdings, the top 10 make up 14.54% of the fund.  Below I’ve created a snapshot of the top 10 holdings:

Fund

State

Weight

Maturity Date

Overland Pk Dev-Ref-B

KS

3.10%

1/1/2032

Tob Settlement Ser 1a

NJ

2.53%

6/1/2029

Ia Fin Auth

IA

1.40%

8/1/2042

Tob Settlement Ser 1a

NJ

1.15%

6/1/2041

Oh Cnty Poll-Ref-A

KY

1.11%

7/15/2031

Capital Trust-A

FL

1.09%

1/1/2048

Sanger Indl Dev Corp

TX

1.08%

7/1/2038

Houston Arpt-Ref-A

TX

1.05%

7/15/2030

Onondaga Civic Dev

NY

1.03%

7/1/2042

Il Fin-A-Admiral At L

IL

1.00%

5/15/2046

Source: Vaneck.com

You will notice in the table above that the maturity dates are quite far into the future.  At 10.91, this fund does have a higher effective duration than many other high-yield bond funds (and a longer average maturity profile as well).  For example, the well-known iShares High Yield Corporate Bond ETF (HYG) has an effective duration of just 4.30.  The SPDR Barclays High Yield Bond ETF (JNK) has a modified adjusted duration of 4.63.  And the AdvisorShares Peritus High Yield ETF (HYLD) checks in with a duration of just 3.41.  In general, higher durations imply a greater risk of price volatility.  In other words, the longer the duration, the more sensitive a bond’s price will be to changes in interest rates.  HYD’s longer duration is something you should seriously consider before making an investment.  From my perspective, buying HYD at a huge discount to NAV after the recent sharp spike in interest rates and in the type of weak underlying economic environment in which we live makes the longer duration less of a concern.  But your investment objectives may compel you to purchase shorter duration funds, thereby not affording you the luxury of taking advantage of the current rare opportunity in HYD.

In terms of the geographical weightings of the fund, a bit more than 84% of HYD’s assets are spread out among 20 states and Puerto Rico.  You can see the diversification among those 20 states and Puerto Rico below:

Geographical Weightings for HYD

Source: Data from VanEck.com, Chart by The Financial Lexicon

At this time, I simply want to make readers aware of the rare opportunity to purchase HYD at a significant discount to NAV and provide some background on the fund.  Later in the week, I will share various insights regarding taxes and HYD.  Specifically, I will discuss the importance of having an understanding of taxable-equivalent yields, private-activity bond interest, and the Alternative Minimum Tax (AMT) when purchasing municipal securities.

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