By
Morningstar
:
By Timothy Strauts
Historically, municipal bonds have been one of the quieter
corners of the investment world. Sure, there was the occasional
single-municipality meltdown, such as what happened to
Orange County, Calif., in 1994
. Still, what made these events so newsworthy was the actual rarity
of these kinds of disasters. That has all changed as municipalities
have been blind-sided by falling tax receipts in the wake of the
housing crash. Defaults are still rare because of the stigma
associated with defaulting. As more municipalities have trouble
meeting their obligations, they will have to make a choice between
making interest payments or paying for basic services like
firefighters.
One way to reduce the risk of municipal defaults is to own a
diversified national municipal bond fund like
iShares S&P National Municipal Bond ETF
(
MUB
) . While an increase in defaults is likely, the diversification
inherent in the fund will help cushion the blow. Aggregate bond
indexes such as
iShares Barclays Aggregate Bond
(
AGG
) and
Vanguard Total Bond ETF
(
BND
) do not include municipal bonds in their holdings.
Municipal-bond funds in general are most suitable for use by
investors in high annual tax brackets for use in their taxable
accounts. The reason is that interest income from municipal bonds
is tax-free at the federal level. Therefore, investors with the
highest marginal tax rates are able to best utilize the
tax-shielding profits and maximize their return on the bonds.
As part of a broader investment structure, investors may also
wish to incorporate a muni-bond fund such as MUB in their muni-bond
laddering strategy as a complement to single-issue holdings.
Individual municipal bonds are fairly illiquid after they've been
issued given most investors' preference to buy and hold them until
maturity. Given that, holding a percentage of your municipal-bond
allocation in the more-liquid ETF form will give you the ability to
sell if you get in a jam--without the risk of getting gouged by the
trading spread.
Fundamental View
In the past year the municipal market has had liquidity issues. A
major factor that is limiting liquidity is that some major
muni-bond dealers are holding less inventory than they have in the
past. The infamous "Volcker Rule" seeks to rein in risk-taking by
limiting the proprietary trading at banks. Maintaining an inventory
of bonds available for sale is considered proprietary trading, so
the major dealers have started reducing the size of their inventory
in anticipation of the new rule. While many speculate that the rule
will not be implemented in its current form, the fear of the law's
current structure is enough to curb market participation. The net
effect of these three factors has created a situation where the
bid-ask trading spreads on bonds have widened dramatically.
The current municipal market is quite different than markets of
the past. Municipalities have budgetary problems that will not be
easily worked out. The housing boom was a major source of income
for most municipalities as property values rose, populations
increased, and fees for permits and other services provided
substantial sources of revenue. Now that housing has crashed,
municipalities are facing tough times while they work to cut costs
to match lower revenues. In June 2010, Warren Buffett commented
about the current state of municipalities by saying, "There will be
a terrible problem and then the question becomes will the federal
government help. If the federal government will step in to help
them, they are triple-A. If the federal government won't step in to
help them, who knows what they are." Most municipal bonds are still
very highly rated and there have been few downgrades, but Warren
Buffett's comments speak to growing concerns among investors.
MUB has a current SEC yield of 1.76%, so an investor in the 35%
tax bracket is getting a tax equivalent yield of 2.7%. With the
10-year U.S. Treasury bond paying a yield of 1.7%, you're getting
1% of additional tax-equivalent yield. The credit issues of
municipals are not an impending panic that will hit the market all
at once like the Greek sovereign-debt crisis. Each municipality has
its own unique and varied issues that will be confronted on their
own schedule. Owning a diversified fund like MUB will help smooth
out any issues an individual issuer runs into.
Portfolio Construction
IShares S&P National AMT-Free Municipal Bond tracks the S&P
National AMT-Free Municipal Bond Index. The fund uses
representative sampling, holding 2,056 of the 9,070 bonds in the
underlying index. The fund's maturity schedule is distributed
fairly equally in five-year buckets ranging from one to 25-plus
years. Overall, the fund has an adjusted duration (a measure of
interest-rate sensitivity) of around six years. The interest
payouts on all of its holdings are exempt from federal income
taxes, and none of them will trigger the Alternative Minimum
Tax.
The states with the top allocations in the index are California
(22%), New York (19%), Texas (8%), Puerto Rico (6%), New Jersey
(5%), and Massachusetts (5%).
Fees
This fund charges a management fee of 0.25%, standard for
municipal-bond ETFs. The estimated holding cost of MUB is currently
negative 0.01%, which means the fund has been outperforming its
index recently. Considering the illiquid nature of the municipal
market, periods of small outperformance and underperformance are to
be expected.
Alternatives
MUB is the largest and one of the more liquid municipal-bond ETFs.
There are a multitude of other offerings that provide
state-by-state exposure and also target more specific maturity
ranges. Those looking for a twist on this sector may wish to look
at
PowerShares Insured National Muni Bond
(
PZA
) . It has expenses of 0.28% and offers exposure to insured
municipal debt with a duration similar to MUB's. The other main
competitor is
SPDR Nuveen Barclays Capital Municipal Bond
(
TFI
) . It has expenses of 0.23% and a longer duration of eight
years.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
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