Muni Bond ETFs Defend Against Bears and Taxes

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Aside from brief hiccups, diversified municipal bond ETFs were a good place to park money in 2008 and early 2009. Tax hikes are looming, so they should retain their appeal. The major question of this asset class is whether to grab higher yields of longer maturities or to retreat to the safety of shorter maturities.

Municipals, or bonds floated by state and local governments and agencies, gave investors a bit of a scare in November and December 2008. Unwinding by hedge funds practically froze the market and caused severe price dips on some kinds of municipal bonds. Especially hard hit were bonds at the margin such as auction rate securities and munis from small agencies or with weak revenue streams.

ETFs, however, owned few of these. As they often do, ETFs avoided carnage by diversifying, sticking to highly liquid securities and avoiding untested vehicles. Broad market muni ETFs took a minor hit and bounced right back as the following 1-year graph of iShares S&P National Municipal Bond ETF ( MUB ) and SPDR Lehman Municipal Bond ETF (NYSEArca:TFI) shows:

For investors still waiting out the vaguaries of the stock market, munis remain compelling as an interest-bearing alternative to cash. And muni ETFs are a fine defense against deflation, with one important caveat. The longer the average maturity, the greater the interest rate risk. Experienced investors are warning that interest rate hikes could be severe.

It might seem tempting to grab the higher yield of longer maturities. Below is a graph of short, intermediate and long ETFs represented by Van Eck's Market Vectors Long Municipal ETF (NYSEArca: MLN), Market Vectors Intermediate Municipal ETF (NYSEArca: ITM), and Market Vectors Short Municipal Bond ETF (NYSEArca: SMB):

In April 2009 MLN yielded a full 3% points more than SMB, tax free. Why pass up this extra income?

One reason is that the Obama Administration is printing dollars like they are going out of style, and the Fed is driving down rates close to zero. Foreign investors especially could seek higher rates and stronger currencies elsewhere. If they do, interest rates are sure to rise regardless of Fed action, and long maturity muni ETFs would be hit hard. Over many years the opportunity cost of locking in sub-market returns is severe. Short maturity funds would be minimally impacted.

In addition to SMB, investors may want to examine iShares S&P Short Term National Municipal Bond Fund ( SUB ), which sports an average bond maturity of only 2.4 years and an average duration of 2.2 years. Duration is considered the more accurate measure of how many years an investor is locked into the fund's present yield. SUB has the lowest figures of any muni ETF and should prove the most defensive, but it pays a paltry 1.6% per year.

The traditional selling point for munis is that dividends are sheltered from federal tax, and specialized ETFs can shelter California and New York investors from state taxes as well. This will no doubt continue to be a strong attraction as tax rates go up on high income individuals to pay off vast federal deficits.

Unlike many asset classes, muni ETFs are uniformly priced fairly. Annual fees are almost all below .30%, and none exceed .40%.

Investment advisors have been particularly enthusiastic about munis because their yields have climbed above those of comparable Treasuries in pre-tax terms, a rare occurrence. Historically investors have settled for muni yields several percentage points lower than Treasury yields, because after tax munis can still deliver higher yields (to high tax bracket individuals), and defaults on munis are exceedingly rare.

Why did the market reverse the muni/Treasury spread? Investors have piled into Treasuries, driving down yields to absurd rates. Also, investors fear defaults of municipalities. State and local governments are in deep financial difficulty across the nation.

Many analysts, however, say the danger is overblown, especially for general obligation bonds of states and state-backed agencies. The Federal government is far less likely to let California or New York default than it would Citibank or Bank of America.

Insured bonds normally give investors extra assurance, but in 2008 insurance had a perverse effect. Insurance companies such as AIG who backed bonds with credit default swaps teetered, and investors downgraded insurance of munis across the board. Meanwhile, many pension funds are required to hold only insured bonds, so investors feared there would be a stampede for the door. Panic selling ensued. Once again, analysts point to these beaten down securities as a bargain. To play this side market, there is PowerShares Insured National Municipal Bond Portfolio ETF ( PZA ).

For California and New York residents, specialized ETFs shelter state and federal taxes. The bonds come exclusively from those respective states. Obviously these are poorly diversified against fiscal mismanagement by state government. ETFs for these megastates include:

  • iShares S&P New York Municipal Bond ETF ( NYF )
  • PowerShares Insured California Municipal Bond Portfolio ETF ( PWZ )
  • iShares S&P California Municipal Bond ETF ( CMF )
  • PowerShares Insured New York Municipal Bond Portfolio ETF ( PZT )
  • SPDR Lehman California Municipal Bond ETF (NYSEArca: CXA)
  • SPDR Lehman New York Municipal Bond ETF (NYSEArca: INY)

  • iShares S&P New York Municipal Bond ETF ( NYF )
  • PowerShares Insured California Municipal Bond Portfolio ETF ( PWZ )
  • iShares S&P California Municipal Bond ETF ( CMF )
  • PowerShares Insured New York Municipal Bond Portfolio ETF ( PZT )
  • SPDR Lehman California Municipal Bond ETF (NYSEArca: CXA)
  • SPDR Lehman New York Municipal Bond ETF (NYSEArca: INY)
  • iShares S&P New York Municipal Bond ETF ( NYF )
  • PowerShares Insured California Municipal Bond Portfolio ETF ( PWZ )
  • iShares S&P California Municipal Bond ETF ( CMF )
  • PowerShares Insured New York Municipal Bond Portfolio ETF ( PZT )
  • SPDR Lehman California Municipal Bond ETF (NYSEArca: CXA)
  • SPDR Lehman New York Municipal Bond ETF (NYSEArca: INY)
  • Van Eck, a small ETF provider which focuses heavily on munis, also provides these specialized products:

    • Market Vectors Pre-Refunded Municipal Index ETF (NYSEArca: PRB)
    • Market Vectors High-Yield Municipal Index ETF (NYSEArca: HYD)

    • Market Vectors Pre-Refunded Municipal Index ETF (NYSEArca: PRB)
    • Market Vectors High-Yield Municipal Index ETF (NYSEArca: HYD)
  • Market Vectors Pre-Refunded Municipal Index ETF (NYSEArca: PRB)
  • Market Vectors High-Yield Municipal Index ETF (NYSEArca: HYD)
  • Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.

    Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.



    The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



    This article appears in: Investing , ETFs


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