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ETFs Disagree With Municipal Indexes

The story in the municipal bond market this month has been bleak. The story in the municipal bond exchange-traded fund ­market has been even bleaker.

Most muni ETFs have gotten clobbered this month, in many cases far more severely than the indexes the funds are designed to track.

Considering that ETFs strive to move in tandem with their indexes, the gap between municipal indexes and their ETF proxies means one of two things: either munis are poised to decline further, or muni ETFs are a steal at these prices.

First launched in 2007, ­municipal bond ETFs attempt to replicate the returns on a ­benchmark index by holding a sample portfolio of bonds in a trust with characteristics that in aggregate are similar to that ­index.

Investors buy and sell shares representing ownership of the trust, and prices for their shares can sometimes drift from the value of the bonds in the trust.

The $2.2 billion iShares S&P National AMT-Free Bond Fund, for instance, hopes to match returns on the S&P National AMT-Free Bond Index. This month, it hasn’t.

The fund’s index last week dropped 1.05%, and the value of the bonds in the fund’s trust slipped 1.08%. Yet the fund’s shares sank 2.3%.

It is a common story in November.

The $235.6 million iShares S&P California AMT-Free fund price as of the end of last week was down 2.7% for the month, compared with a decline of 1.4% in its underlying index.

Many municipal ETFs now trade at significant discounts to the value of the bonds they hold. The price of Van Eck Global’s Market Vectors high-yield fund on Friday was 2% less than the marked value of the bonds it owns. The iShares national fund closed Friday at a discount of 1.3% from the value of its assets.

Either municipal ETFs have fallen too far, muni indexes haven’t fallen far enough, or both.

The municipal team at Citigroup last week in a report wrote that ETFs have fallen too far. The team advised clients to buy the funds, arguing that the discounts to net-asset value did not reflect the reality of the bond market.

“The move of the ETFs was too abrupt and strong to account for the weaker price action of long-dated muni tax-exempt market,” wrote the team, which is led by George Friedlander. “This sell-off is technical in nature and should be taken advantage of.”

Monday was another rough day for the 30-fund municipal bond ETF ­industry, which has $8.3 billion in assets. The ­iShares national fund plunged another 1.85%.

It has been a rotten month for fixed income in general, with 10-year Treasury yields jumping 24 basis points and 30-year yields leaping 34 basis points.

The price movements of municipal ETFs in theory could reflect investors’ perceptions that indexes could move lower still.

“The share price is maybe a little bit ahead of the movement in the net asset values,” said James Colby, municipal strategist at Van Eck, which runs five muni ETFs. “I think there’s an expression of a movement to the downside being demonstrated with muni ETFs, knowing that we’ve got substantial supply to work through. The demand side, which is cash flowing into mutual funds, has diminished, setting us up for a correction.”

John Donaldson, director of fixed income at Haverford Investments, said municipal ETFs show that investors do not believe the pricing services’ quotes that serve as the basis for index values.

Many dealers yesterday were offering bonds at discounts to the listed asset price, he said, suggesting indexes based on those quotes will eventually come down to align with reality.

Donaldson said the gap between ETF prices and quoted municipal-bond asset values is about “half & half” — the ETFs selling off too much and the indexes not falling enough.

Muni ETFs have only been around a few years, so it is hard to tell how reliably share prices presage moves in target indexes. Some funds dropped sooner and faster than their target indexes during the financial crisis, but it’s not clear whether that was because investors were positioning for shifts in the indexes or because ETFs simply respond to illiquidity more swiftly than bond indexes.

“When we see a fast-moving market, you’ll see some investors react to that, and there’ll be some momentum behind the direction of trades,” said Matt Tucker, managing director of fixed-income strategy for BlackRock, which owns iShares. “You will see some periods like this, when you have a dislocation.”

Tucker said ETFs often reflect ­information before it shows up in bond indexes.

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