Historically this asset class has delivered steady gains, but
during the financial meltdown in October 2008 it dipped severely
before recovering quickly. In November 2010 it dropped sharply
again. Short-term the question is whether munis can snap back
again. Long-term the question is whether volatility is here to
stay.
We think munis are likely to snap back as they did before,
especially given how little is needed to recover. Lately the
culprit has been California which is flooding the market with
general obligation bonds. Muni
ETFs
showed resilience during this recession. Munis have for solid
stretches been as steady as Treasuries. It helps that munis are
not a natural target for hot money. The core holder (directly or
via funds) of the municipal bond is the high net income
individual seeking relief from Federal taxes. This is a
particularly patient investor.
The 2010 slide seen alone looks scary, but next to other asset
classes, a 6% or 7% drop is nothing. And seen against 2008 it was
a minor blip as a graph of iShares S&P National Municipal
Bond ETF (
MUB
) shows:
Another popular medium-long duration (7-8 years) ETF is SPDR
Lehman Municipal Bond ETF (NYSEArca:TFI).
Long-term, volatility should remain historically high as major
forces tug at munis. On the one hand, states and municipal
agencies are borrowing unprecedented sums to fund huge budget
shortfalls and putting their credit ratings at risk. On the other
hand, more investors are seeking stable income, and more
investors are creeping into high tax brackets where munis have an
edge against taxable bonds. These opposing forces are enormous
and unpredictable and foreshadow increased volatility, although
nothing like what we can expect from equities.
As with other bonds, munis face interest rate risk. The higher
yield of longer maturities such as with Van Eck's Market Vectors
Long Municipal ETF (NYSEArca: MLN) may be tempting, but we
recommend holding it with sell limits in place. If what many call
the bond bubble bursts and investors demand higher yield, a slide
could be precipitous. Federal Reserve officials are pulling out
all their tricks to lower interest rates with little effect. This
is a warning sign.
Market Vectors Intermediate Municipal ETF (NYSEArca: ITM)
would be less impacted from interest rate gyrations. True havens
would be Market Vectors Short Municipal Bond ETF (NYSEArca: SMB)
and iShares S&P Short Term National Municipal Bond Fund (
SUB
) which sport average durations of just 2 years or so. Yields are
paltry, however, at about 2%.
Another short duration alternative is the PowerShares VRDO
Tax-Free Weekly Portfolio (NYSEArca:PVI). This more complex ETF
achieves extremely short duration by contractually modifying
long-duration bonds to reset their interest rates on a weekly
basis. The principal is protected with a put feature and/or
insurance. There is some risk in the soundness of the agreements
themselves, but they survived 2008 fine so they appear solid. PVI
pays around 3% yield and could be a smart choice for the
sophisticated investor who is wary of interest rates but
confident that credit markets will not disintegrate.
The muni market is rife with broker collusion and
unconscionable fees for the individual investor. ETFs are an
ideal way to remove these barriers because their professional
managers avoid these traps. An added bonus is low fees. ETFs in
municipal bonds seem to all have modest fees under about
0.30%.
Insured bonds normally give investors extra assurance,
although insurance had a perverse effect in 2008 when insurance
companies backing munis teetered. Panic selling of insured bonds
made them cheaper than uninsured bonds. In 2011 and beyond
PowerShares Insured National Municipal Bond Portfolio ETF (
PZA
) will likely deliver protection and stability normally
associated with insurance.
For California and New York residents, specialized ETFs buy
bonds exclusively from one of those tax-happy states and allow
shelter from state tax for their residents. These 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)
Van Eck also provides these specialized products:
- 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.