Municipal bond funds are down for the year after a third-quarter selloff erased the first-half gain

Through October 12, a holder of these funds is down for the year, after being ahead at the end of June.

These funds hold bonds from U.S. states, cities and other public borrowers. On the large national funds, the interest is generally exempt from federal income tax.

A gain, then a larger loss

The Bloomberg Municipal Bond Index gained 2.3% in the six months through June 30, including interest. Western Asset, in its October 8 municipal note, said the same index lost 6.3% in the third quarter.

Across 63 municipal bond exchange-traded funds, $153 billion in all, the median fund lost 6.0% in the quarter and 3.7% for the year through October 12. The quarter's loss was larger than the year's, so a holder in from January was ahead at the end of June. The third quarter took that back.

Over the twelve months through October 12, a longer stretch than the year to date, no fund with a full year of history had a gain. The smallest loss in that window, including the income paid, was 0.5%, at the Goldman Sachs Municipal Income ETF, AGMUB.

What pulled prices down

Benchmark tax-exempt yields rose 1.12 to 1.24 percentage points in the quarter and reached the highest levels since the 2007-2008 credit crisis, the Municipal Securities Rulemaking Board said in its October summary. The 10-year benchmark peaked at 4.22% on September 29 and closed September at 4.11%.

The MSRB said the 10-year tax-exempt yield rose about 0.8 percentage points from the end of June to July 22, then held in a narrow range through August, before September added 0.61 to 1.05 percentage points, depending on maturity.

Treasury yields rose over the same quarter, by less. The 10-year Treasury yield went from 4.44% on June 30 to 5.29% on September 30, up 0.85 percentage points, against 1.12 to 1.24 percentage points for the tax-exempt benchmarks.

On September 16 the Federal Reserve raised the target range for the federal funds rate by a quarter of a percentage point, to 3.75% to 4%.

Morningstar wrote on October 2 that after a strong first half, a mix of rising interest rates and too much supply led municipal bonds to sell off more sharply than every major fixed-income sector except long-term Treasuries. On why municipals fell further than Treasuries in September, the MSRB said:

"The volume of selling by investors was likely a major reason why the tax-exempt market dramatically underperformed the Treasury market in September."

The 4.11% municipal yield and the 5.29% Treasury yield are not the same kind of income. Interest on the large national funds is generally free of federal income tax. The Treasury yield is not.

What the large funds returned

The Vanguard Tax-Exempt Bond ETF, AVTEB, and the iShares National Muni Bond ETF, AMUB, together hold 64% of the category's assets.

Counting the income paid, the Vanguard fund was down 3.6% for the year through October 12. The iShares fund was down 3.5% for the year and lost 5.3% in the third quarter. That fund tracks the ICE AMT-Free US National Municipal Index, not the Bloomberg index, so the 5.3% and the index's 6.3% are losses on different portfolios.

The 30-day SEC yield, a standardized figure based on the last 30 days of income after fees, was 4.16% for the iShares fund as of October 8 and 4.38% for the Vanguard fund as of October 9. Distributions from the iShares fund over the twelve months through October 1 were 2.7% higher, per share, than over the twelve months before.

Vanguard charges 0.03% a year and iShares charges 0.05%, against a median fee of 0.3% in the category. The cheaper funds still finished the year about where the median fund did.

The iShares California Muni Bond ETF, ACMF, lost 5.4% in the quarter, close to the national iShares fund.

The broad taxable bond market lost less than municipals, and still lost. The iShares Core U.S. Aggregate Bond ETF, AAGG, fell 3.5% in the quarter and 2.7% for the year through October 12. The median municipal fund's quarter was 2.5 percentage points worse. The State Street SPDR S&P 500 ETF, ASPY, gained 2.4% in the quarter and 15% for the year.

Buyers of the funds, sellers of the bonds

Municipal bond exchange-traded funds took in $23 billion in the third quarter and $55 billion in the year through September 30, the MSRB said, using Investment Company Institute figures. That money arrived while prices were falling.

Tax-exempt mutual funds had $4.3 billion of net outflows in the quarter, after inflows of $16 billion in each of the first two quarters.

The September selling the MSRB described was investors selling bonds. Holders of the exchange-traded funds were on the other side, still adding.

A holder of the two large national funds, through October 12, has a loss for the year and a federally tax-exempt yield a little over 4%. The year paid the interest. It did not protect the price.