Pros and Cons of Muni Bond ETFs

With the continuation of the Fed’s zero interest policy, investors are hunting for higher yields, and Muni ETFs have been the target as well. There are some pros and cons to investing in Munis in this market environment as discussed in “Muni-bond ETFs in a state of flux:”

Investors starved for yield continue to stuff cash into exchange-traded funds that target municipal bonds, even as the prospect of higher interest rates and credit downgrades loom over the sector.

Still, investors need to weigh the risks of muni bonds. Rising interest rates could hurt bond prices across the board, and many states are wrestling with budget gaps in the recession due to falling tax revenue.

Muni bonds help states and localities pay for public projects such as education and transportation projects. With nearly $2 billion in assets, iShares S&P; National AMT-Free Municipal Bond Fund (MUB) is the largest muni-bond ETF. It was up 9.2% over the 12 months through March 11.

Low-fee ETFs allow investors to buy a basket of bonds in a single trade rather than researching and purchasing individual securities.

Hazard signs

“Storm clouds” are brewing over state and municipal governments, Morningstar said in a recent report.

“They’ve seen tax revenues decline just as the demands on their resources are increasing,” the report said. “California may be capturing all the headlines, but many other states have seen their financial conditions deteriorate.”

Rising interest rates are another big risk for municipal bonds, since bond prices and rates move in opposite directions. Investors concerned about higher interest rates can get some protection by moving into shorter-maturity bond ETFs.

Muni-bond prices plunged and yields surged in late 2008 when credit markets panicked. Muni bonds were hit by the collapse of dealers Bear Stearns and Lehman Brothers, coupled with the trouble in the auction-rate securities market and muni-bond insurers going out of business. The chaotic and illiquid market contributed to index tracking error in muni-bond ETFs at the time.

The so-called yield spread between munis and comparable Treasury bonds blew out to dramatic levels during the credit crunch. Part of the reason is that anxious investors piled into Treasurys for safety and pushed government-bond yields down.

With the introduction of government stimulus measures, those yield spreads snapped back as muni-bond prices rallied, giving investors a “once-in-a-generation-type year in 2009,” said Jim Colby, strategist at Van Eck Global, which offers a suite of muni-bond ETFs.

Despite the recovery, investors continue to worry about budget shortfalls, declining tax receipts and cuts in services. Still, investment-grade muni bonds have had extremely low historical default rates. Defaults do happen though; Orange County declaring bankruptcy in 1994 is one infamous example.


There are some reasons to be optimistic about muni bonds even with the recession and their recent performance

Some investors are drawn to munis because the interest income is usually exempt from federal income taxes, and also from state taxes in some cases. Tax cuts passed during the Bush administration are set to expire at the end of 2010, which should make muni bonds even more attractive.

Munis usually have lower yields than comparable Treasury bonds, but the tax savings can compensate for the difference.

However, investors should keep an eye on a bill that was recently introduced by Sens. Ron Wyden, D-Ore., and Judd Gregg, R-N.H., that would eliminate key tax advantages of muni bonds.

Another factor working in favor of muni bonds is the Build America Bond program implemented by the Treasury Department last year. Build America Bonds are taxable bonds issued by state and local governments, while 35% of the interest income is rebated back to the issuer by the Treasury. The program is scheduled to expire at the end of 2010.

“The primary goal of the program was to reduce the cost to the issuing municipalities by offering higher rates (subsidized by the government) in order to draw in non-traditional buyers of municipal debt,” Morgan Stanley analysts wrote in a January research note.

Choosing muni-bond ETFs

At the end of January, there were 27 muni-bond ETFs listed in the U.S. with a combined $6.2 billion in assets, according to Investment Company Institute.

Investment managers that oversee muni-bond ETFs include BlackRock, Grail Advisors, State Street Global Advisors, Invesco PowerShares, Van Eck and Pimco.

Some of the more-diversified options include Market Vectors Long Municipal Index ETF (MLN) , PowerShares Insured National Muni Bond (PZA) and SPDR Barclays Capital Municipal Bond (TFI) .

There are also ETFs targeting various maturities, and funds for individual states including California and New York.

Meanwhile, the PowerShares Build America Bond Portfolio (BAB) was launched in late 2009 and has gathered roughly $190 million in assets.

The chart above shows a 2-year comparison of all Muni ETFs mentioned in this article. It’s obvious that munis will head south during bear market periods just as any other asset class. So the use of a sell stop is imperative here as well.

Personally, the hazards mentioned above outweigh the tailwinds, because of the ever increasing budget shortfalls, the end which is nowhere near. If I had to choose, I would stay away from State specific Muni ETFs and select one like MUB, which is widely diversified across state lines.

Additionally, it sports a 3.6% annual tax-free dividend yield and, with an average daily trading volume of $10 million, it should allow you to move in and out fairly quickly.

Disclosure: I currently do not have any holdings in the ETFs mentioned above.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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