This month’s panic-driven selling across municipal bonds — fueled by the boom in ETFs — is proving a mixed blessing for investors in a normally sedate market corner.
As the tariff-spurred turmoil erupted in recent weeks, money managers navigated the immense selling pressure via exchange-traded funds, which lived up to their billing as efficient vehicles for price discovery. That’s a boon in an asset class where some securities can go months without trading.
At the same time, that ease of trading also contributed to the biggest three-day drop for munis since the pandemic, with ETFs accounting for more than 40% of the $3.3 billion in outflows from the market for local and state government debt in the week ended April 9, according to LSEG Lipper Global Fund Flows.
The episode underscores how these trading tools, which now command more than $137 billion in muni assets, are speeding up markets of all stripes — boosting market accessibility and price efficiency, while potentially amping up the drama on Wall Street.
ETFs are “a double-edged sword,” said John Miller, head of municipal bonds at First Eagle Investment Management. “They get heavier volatility of flows for sure, and because they are an ETF they need to respond to those immediately, usually within a few hours.”
Since President Donald Trump unleashed reciprocal tariffs on April 2, “ETFs have continued to offer investors the ability to manage their exposures at low costs,” Steve McFee, senior portfolio manager at Vanguard, who oversees the firm’s core tax-exempt bond ETF, said in an email.
Muni investors have more easy-to-trade options as money managers have rushed to launch their own ETFs. Muni ETF assets have more than doubled from 2020, according to quarterly data compiled by Bloomberg and the Federal Reserve.
‘Liquidity Valve’
The rise of ETFs as well as separately managed accounts over the past three years have led to more trading volume in smaller increments, meaning a lot of trades are done using algorithms and that ends up making market moves more rapid, according to Matthew McQueen, head of global mortgages and securitized products and municipal banking and markets at Bank of America.
McQueen described muni ETFs as a “liquidity valve — where you had something trading that was furnishing a lot of price discovery, that had it not been there, I think the market would’ve been slow to widen.”
In the front half of last week, 10-year municipal bond yields soared more than 80 basis points as financial markets were upended by a slew of tariff announcements. The muni market has since settled into its usual narrow trading range, with yields down by about 17 basis points so far this week. Daily muni ETF data also indicates a return to inflows, according to a JPMorgan Chase & Co. report.
To be sure, retail investors make up a larger portion of the muni market than any other fixed-income asset class irrespective of whether their exposure is in ETFs, SMAs or mutual funds, and those retail investors often sell during times of extreme volatility, said Craig Brandon, co-head of municipals at Morgan Stanley Investment Management.
ETFs bolster liquidity of munis but the relationship is contingent on market conditions, according to research by Justin Marlowe, a research professor and director of the Center for Municipal Finance at the University of Chicago. When daily returns are negative, ETFs can offer investors higher yields.
The trading doesn’t necessarily cause yields to move in a certain direction but can “amplify and accelerate” the shifts, said Marlowe.
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