Many fear that rising interest rates will crush income-oriented portfolios. Get over it — that was last year’s news. In fact, the vast majority of high-yielding assets have been the best performers of 2014, including utility stocks, REITs as well as long-dated U.S. Treasuries.
Naturally, some investors still wish to hedge against rate risks. What these folks need to recognize is that rising interest rates are currently threatening the short end of the yield curve, not the long end. Safety-seekers have actually bid up the price on longer maturity bonds. It follows that the yield curve is flatter than at any point since October of 2009.
Investors who are wary of getting burned by erratic price swings in longer-term bonds can still hedge against the possibility of the Fed influencing shorter-term rates. The answer? Short-term high yielding municipal bond ETFs.
Here are three reasons that heavily taxed investors ought to look at shorter-term, higher yielding Muni ETFs:
1. Favorable Spread. Earners who feel they are getting fleeced by a 33% or 39.6% tax bracket would be reasonably well compensated for taking on extra risks in higher yielding munis. For instance, the 20-year average yield spread between investment-grade munis and junk-rated munis is usually in the neighborhood of 3%. Right now, that spread is far more favorable at 3.75%. Market Vectors Short-Term High Yield Muni (SHYD) lists a 30-day SEC yield of 4.7% with a taxable equivalent yield for the top tax bracket near 7.75%. Market Vectors Short-Term Muni (SMB) lists a 30-day yield of 0.92% with a taxable equivalent for the top tier at 1.52%. The reward for pursuing SHYD is worthy of the additional risk.
2. Lower Default Rates. Puerto Rican debt woes spread a dark cloud over higher yielding munis. Yet the default rate for higher yielding munis has been declining. Specifically, the default rate for the S&P Municipal Bond High Yield Index hit 1.5% in 2011. In 2013? The default rate fell to 0.8%. Less defaults combined with greater yield spreads equate to an enhanced risk-reward relationship.
More adventurous souls might even prefer Market Vectors High Yield Muni (HYD) to Market Vectors Intermediate Muni (ITM). The former boast a 30-day SEC yield near 5.75% and a taxable equivalent for the top marginal bracket of 9.5%. Compare that to a taxable intermediate Treasury bond offering like iShares 7-10 Year Treasury (IEF). Can its 2.4% of income offset the possibility of modest price depreciation? Even with the possibility of IEF’s price appreciating, HYD would likely benefit even more from price gains.
3. Volatile Bond Market in 2013, Volatile Stock Market in 2014. The January 2014 sell-off for the S&P 500 was more volatile than anything stock investors had to deal with in the entire 12 months that had preceded it. Commodity price inflation, weak macroeconomic data, geopolitical risk in Ukraine as well as murky forward guidance by the Federal Reserve have collectively toyed with stock investor confidence over the last three months. In contrast, bond prices have actually gained ground on worries that the muddle-through U.S. economy may not be capable of handling less stimulus from the Fed.
So what should investors make of an economy that is neither growing considerably nor weakening substantially? After all, the dynamic certainly benefited those who overweighted domestic equities in 2012 and 2013. Today, though, the Fed’s reduction in the levels of quantitative easing provide an easy excuse for profit-taking. The last few days have witnessed enormous selling pressure in biotech, social networking, cloud computing and alternative energy.
In contrast, the stability of the 10-year yield is providing comfort to income-oriented investors. Not only has the 10-year jockeyed between 2.6% and 2.85% for the better part of two months, but the tight trading range encourages muni advocates to acquire higher-yielding possibilities. I like the short-term high-yielding muni space via Market Vectors Short Term High Yield Muni ETGF (SHYD). More aggressive folks might gravitate toward the SPDR S&P High Yield Muni Bond Index ETF (HYMB).