HYD ETF: Question & Answer

This blog is intended to answer frequently asked questions on high-yield municipal bonds and, more specifically, the VanEck High Yield Muni ETF (HYD).

• What are high-yield municipal bonds, and how big is this market?
• What makes high-yield municipal bonds attractive relative to other types of bonds?
• Are high-yield municipal bonds safer than high-yield corporate bonds?
• What makes HYD unique?
• How is the fund’s index constructed?
• Why does the fund include investment grade bonds?
• Why does the index cap its exposure to not-rated bonds?
• Why could slippage be higher in this asset class?
• How does the portfolio management team decide which bonds in the index to own?
• How to buy VanEck ETFs?

1. What are high-yield municipal bonds, and how big is the market?

High-yield municipal bonds are a type of debt security issued by a state, municipality, county, or other local government with credit ratings that are below investment grade. Investors in high-yield securities are compensated with higher interest payments for taking on additional credit risk.

These bonds are issued to raise capital for various types of public infrastructure and public benefit projects. High-yield municipals can be issued as either general obligation bonds or revenue bonds. General obligation bonds are backed by the full faith, credit, and taxing power of the issuer. In contrast, revenue bonds are secured by the revenue generated by a specific project that is being financed.

At the end of the second quarter of 2023, SIFMA estimated that over $4.04 trillion worth of municipal bonds are currently outstanding. Of those, approximately $258.3 billion are high-yield and non-rated bonds.

2. What makes high-yield municipal bonds attractive relative to other types of bonds?

• Potential for Higher Yields: relative to investment grade bonds, non-investment grade bonds can potentially offer lenders higher yields in exchange for taking on the additional risk associated with lower credit quality.
• Tax advantages: the interest income generated by municipal bonds is generally exempt from federal income tax and, in some cases, exempt from state and local taxes, as well. Investors in higher tax brackets can see the benefits of investing in municipal securities when comparing a municipal bond’s taxable equivalent yield to the yield on a taxable bond.

Asset Class Yield Comparison - 11/30/2023

Source: ICE Data Services as of 11/30/2023. Please see below for definitions of all indices referenced herein.

• General Stability of Municipal Issuers: Municipal bonds are issued by state and local governments, which may be considered more stable than corporate entities. This perception of stability can be appealing to investors seeking a balance between income generation and capital preservation.
• Economic Development Projects: High-yield municipal bonds are often issued to finance economic development projects, such as infrastructure improvements, housing projects, or other initiatives aimed at stimulating local economies. Some investors may find the prospect of contributing to community development appealing.
• Diversification: Adding high-yield municipal bonds to an investment portfolio can enhance diversification, spreading risk across various asset classes and potentially lower the portfolio's overall risk.

3. Are high-yield municipal bonds safer than high-yield corporate bonds?

It is broadly understood that municipal bonds have key characteristics that cause differences in their credit profile relative to debt instruments issued by corporations.

In many instances, municipal bonds are backed by the full faith, credit, and taxing authority of a government entity. Because of this, many investors perceive municipal bonds to be higher in credit quality than many corporate securities. Data also support this thesis.

According to Moody’s, the average cumulative default rate (CDR) in the municipal bond market has been stable or has fallen over the past five years. The same study indicates that since 1970, the average CDR for the high-yield municipal sector has been 1.19%. The corporate bond market tells a vastly different story. High-yield global corporate bonds have an average CDR of 4.03% since 1970.

While no debt security is safe from default or loss of principal, it can be concluded that municipal bonds have historically observed a materially lower default rate than global corporate bonds.

4. What makes HYD unique?

• Smart Exposure: HYD’s index is designed with intention. It offers broad exposure to the high-yield municipal bond market with unique features to enhance the credit and liquidity profile of the portfolio.
• Cost Efficiency: HYD has the lowest fees in the peer group, which includes other high-yield muni ETFs.¹ The fund’s low fees can potentially enhance investors’ total returns.
• Attractive Yield: The fund has historically offered an attractive taxable equivalent yield compared to other high-yield municipal funds and other fixed income offerings.
• Enhanced Liquidity: When evaluating the fund’s average daily trading volume (ADTV), investors will find that HYD generally trades at relatively high volumes and narrow spreads than trading individual high-yield bonds. This may reduce transaction costs.
• Credit Quality: The fund’s index includes specific mechanisms to improve the underlying credit in the portfolio. This credit-enhancing feature may contribute to decreased volatility and illiquidity.
• Fund Management: A dedicated municipal bond portfolio management team with a proven track record tracks HYD’s index via a robust optimization process.

5. How is the fund’s index constructed?

VanEck’s High Yield Muni ETF (HYD) seeks to track the ICE Broad High Yield Crossover Municipal Index. This index tracks the performance of lower-rated and unrated U.S. dollar-denominated tax-exempt debt publicly issued by U.S. states and territories and their political subdivisions in the U.S. domestic market.

The index’s exposure can be broken down as such:

• 70% core high yield and unrated municipals.
• 25% core BBB municipals.
• 5% core A municipals.

Additionally, the index implements the following constraints:

• 30% cap on unrated securities.
• 10% cap on U.S. territories.
• 5% cap on zero-coupon securities.

6. Why does the fund include investment grade bonds?

The index’s inclusion of investment grade (IG) municipal bonds provides a liquidity-enhancing feature. High-yield municipal bonds generally trade less frequently than their investment grade equivalents. The IG allocation helps the fund reduce slippage in the instances where the underlying securities are being traded.

7. Why does the index cap its exposure to not-rated bonds?

Bonds that are not rated by an established credit rating agency are generally considered to be riskier, and it can be difficult to derive a correct valuation or price. The fund’s index caps its exposure to these seemingly riskier investments to mitigate the potential volatility, illiquidity, and credit concerns associated with not-rated securities.

8. Why could slippage be higher in this asset class?

The high-yield section of the municipal bond market generally trades less frequently than other fixed-income securities, as previously discussed. These wider spreads cause difficulties for traders to reach the best price obtained by the index when trading to replicate the index.

Additionally, prevailing market conditions have limited issuers’ willingness to borrow, which has subsequently muted the supply of new municipal issuance. As this is ongoing on the supply side of the equation, the demand for the newly issued bonds persists. This limited supply and exceptional demand story leads to very competitive pricing once the bonds hit the open market.

9. How does the portfolio management team decide which bonds in the index to own?

The portfolio management team’s optimization process allows the portfolio to track the index without holding every constituent security. The graphic below illustrates this process.

^* International Data Corporation (third-party pricing service.) The municipal income ETF investment process is subject to change at any time. For illustration purposes only.

10. How to buy VanEck ETFs?

Learn more here.

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