Report explores impact of muni bond ETFs on the municipal market

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WASHINGTON - The rapid increase in the popularity of exchange-traded funds hasn't had any statistical impact on municipal market liquidity so far, though that could change if muni ETFs continue to gain prominence, the Municipal Securities Rulemaking Board's chief economist said Wednesday.

MSRB chief economist Simon Wu drew those conclusions in a 24-page report he co-authored with researcher Meghan Burns titled “Municipal Bond ETFs: Liquidity Impact on the Municipal Bond Market.”

Muni bond ETFs are a small but fast-growing segment of the overall ETF space, and there has been concern among some that an increase in ETF ownership could result in a decline in market efficiency. Wu found no such effect to date, but urged that additional research be done to draw firmer conclusions.

An ETF is a security that tracks an index, commodity, or basket of assets but trades like a stock on an exchange. An ETF holds assets such as stocks, commodities, or bonds. The first ETF was launched in 1993, and the first fixed-income ETF appeared in 2002. The first municipal bond ETF, iShares National Muni Bond ETF, was formed in September 2007 and remains the largest muni ETF by net assets to date at more than $9 billion, according to the MSRB.

ETFs have grown enormously in popularity since the 1990s, and the last few years have seen a surge in bond ETFs including those holding munis.

“Compared to corporate bond and government bond ETFs, municipal bond ETFs are relatively new to the landscape, making up about 1% of all ETF assets,” the MSRB study said. “However, their growth rate of 35.4% annually from 2008 through 2016 has outpaced the average growth among all fixed-income ETFs, as well as the corresponding municipal bond market given that the total amount of municipal bonds outstanding has been relatively steady in recent years.”

As of 2017, the top municipal bond ETFs cited in the study average over 5 million shares, or a total of $250 million, traded per day in the secondary market.

The study discusses a “liquidity mismatch” between muni ETFs and the underlying bonds themselves. While the ETFs often trade frequently throughout the day, some of the underlying securities can be more difficult to trade and result in a “lag” in the pricing of those bonds, Wu and Burns wrote. This could cause a deviation between ETF prices and the net asset value, which is the value per share of a fund.

Regulators have expressed concern about that very thing, particularly in times of increased market stress. In a Sept. 8, 2017, speech in Washington, for example, Securities and Exchange Commission member Michael Piwowar talked about ETFs and said there was “mixed” evidence about whether pricing “noise” created by ETF ownership could be hurting market efficiency.

The study, which utilized data from 2007 to 2017, found no evidence of harm to muni trading.

Despite the steady growth of municipal bond ETF assets since 2007, we found no evidence of an impact on municipal market liquidity,” said Wu. “However, the impact could certainly change over time with the continued growth of municipal bond ETFs, which, even after an explosive decade of growth, still represent less than 1% of all municipal securities-related investments.”

The study suggests further research projects, such as separating munis held in ETFs from other munis and tracking the trade volume of the two groups separately.

“Regardless of the ultimate impact on the corresponding markets for individual securities,” the paper concludes, “improving liquidity for the municipal bond market is essential for keeping both markets well-functioning and for providing both investors and municipal entities more efficient avenues to access the capital markets.”

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