Municipal Bond ETF Declines Most Since August After Rallying for Five Days

The biggest exchange-traded fund tracking the municipal debt market fell the most in five months after a weeklong rally pushed it to the highest price relative to its bonds since 2009.

The iShares S&P National AMT-Free Bond Fund lost 1 percent to $109.83 as of 2:41 p.m. in New York, falling from a record, according to data compiled by Bloomberg. The ETF rose 2.5 percent in the previous five sessions, the biggest advance since January 2011, after declining bond sales by states and local governments made the security one of the only ways to capture gains in the municipal market.

Eric Lichtenstein of Knight Capital Group said the tumble may reflect arbitragers trying to narrow the gap between the ETF’s price and the value of its underlying securities. The decline on a day in which municipal bonds were appreciating came after the fund surged to a 2.4 percent premium to its net asset value yesterday, the highest in three years.

“That premium triggered some people to put it back in line,” Lichtenstein, the Jersey City, New Jersey-based managing director of ETF trading at Knight, said in a telephone interview today. “The market makers are supposed to keep these in line, so when they get to a level where it’s not consistent with historical trends, that’s when the market makers step in.”

The iShares S&P National AMT-Free Bond Fund climbed 0.3 percent to $110.93 yesterday to extend its five-day gain to 2.5 percent. That compared with a 0.8 percent five-day advance in the S&P Municipal Bond Index, on which the ETF is based.

Mimicking Munis

Gains in the ETF, known by its ticker symbol MUB, beat the underlying debt because money managers who have run out of bonds to buy are using it to mimic returns in the municipal market, according to Dodd Kittsley, the New York-based head of the due diligence group at BlackRock Inc.’s iShares unit. States and cities sold $258.26 billion of fixed-rate debt in 2011, down from $407.68 billion the year before, according to data compiled by Bloomberg.

“The supply in the muni market’s been highly constrained,” Kittsley, whose firm oversees $3.3 trillion, said in a telephone interview yesterday. “The premium’s really a reflection of MUB as an access vehicle for the market and reflects this asymmetric liquidity in the underlying.”

Yields on benchmark 20-year municipals fell 9.1 basis points on Jan. 9 to 3.3 percent, the biggest one-day drop since Dec. 7, according to data compiled by Bloomberg. A basis point is 0.01 percentage point.

Large orders of ETFs are made through so-called authorized agents of the sponsors, who purchase blocks of the underlying assets and trade them with the fund to create new shares. The mechanism helps an ETF’s share price stay close to its net-asset value as investors arbitrage discrepancies between the fund shares and underlying holdings.

‘Just Holding’

Illiquidity in the municipal market can raise costs for authorized agents and increase the price of the ETF. Issuance fell after the federal Build America Bonds program, which offered states and localities a 35 percent subsidy on interest costs, ended on Dec. 31, 2010.

Investors have put more than $32 million into the ETF in the week through yesterday and more than $471 million in the last year, data compiled by New York-based XTF Inc. show.

“If you have an illiquid market and there’s not much supply out there, everyone’s just holding onto their bonds, then any sort of creation is going to move the price of the ETF even if it’s a small one,” said Timothy Strauts, a Chicago-based ETF analyst at Morningstar Inc., in a telephone interview.

Whitney Prediction

Municipals outperformed other asset classes after the “hundreds of billions of dollars” of defaults predicted by bank analyst Meredith Whitney in December 2010 didn’t happen. States and cities in the $3.7 trillion municipal market withstood the longest recession since the 1930s as they reduced spending to close deficits and tax collections rose for eight consecutive quarters through Sept. 30, the longest stretch of gains since 2008, the Census Bureau said Dec. 20.

Pacific Investment Management Co., which runs the world’s largest bond fund, has boosted holdings of U.S. municipal debt to the most in more than five years and may buy more. Adding securities that outperformed Treasuries, stocks and commodities last year may bolster Bill Gross’s $244 billion Total Return Fund, which lagged behind others in 2011. It returned 4.16 percent compared with the average 4.78 percent of its peers last year, according to data compiled by Bloomberg.

“This seems to a very logical place to expect asset allocation in the new year,” said Nicholas Colas, the New York- based chief market strategist at BNY ConvergEX Group LLC. “The world is searching for yield and worried about the incremental taxes implied by ever-rising federal debt. Munis are at the intersection of those trends.”

To contact the reporters on this story: Inyoung Hwang in New York at ihwang7@bloomberg.net; Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Mark Tannenbaum at mtannen@bloomberg.net