Muni funds have a lot of appealing features right now for income-minded investors. And economists believe the muni rally might not be finished yet.
So you thought Treasury bonds were the only winning asset class in 2008. Guess again.
Although U.S. Treasuries certainly benefited immensely last year from a massive investor flight to safety worldwide, several other asset classes quietly held their value or even enjoyed modest gains last year. Those unsung heroes included investment-grade corporate bonds, managed futures and gold.
But surprise of surprises, municipal bonds—the often overlooked tortoise of the fixed-investment income world—also performed remarkably well in 2008.
Retirees and income-oriented investors alike enjoyed gains averaging 4.6% in the six national, short and intermediate-term tax-free municipal bond ETFs on the market. Those were:
- The iShares S&P Short Term National Municipal Bond Fund (NYSE: SUB)
- The SPDR Barclays Capital Short Term Municipal Bond ETF (NYSE: SHM)
- The Market Vectors Short Municipal Index ETF (NYSE: SMB)
- The Market Vectors Intermediate Municipal Index ETF (NYSE: ITM)
- The iShares S&P National Municipal Bond Fund (NYSE: MUB)
- The SPDR Barclays Capital Municipal Bond ETF (NYSE: TFI)
Even the six state-specific municipal bond ETFs for California and New York fared well in 2008—despite concerns about declining state tax revenues. Those were:
- The SPDR Barclays Capital California Municipal Bond ETF (NYSE: CXA)
- The PowerShares Insured California Bond Portfolio (NYSE: PWZ)
- The iShares S&P California Municipal Bond Fund (NYSE: CMF)
- The SPDR Barclays Capital New York Municipal Bond ETF (NYSE: INY)
- The iShares S&P New York Municipal Bond Fund (NYSE: NYF)
- The PowerShares Insured New York Municipal Bond Portfolio (NYSE: PZT)
Losses for the group ranged a modest 2.1% to 12.6% last year. These six state ETFs have already recovered more than 8.9% from their December 2008 lows.
Californians Devour New Munis
Some experts believe that as goes California, so goes the nation—particularly in the municipal bond world.
Six months ago, bond dealers were practically giving California munis away. Recently, however, California municipal bonds have gained considerable traction.
Consider California's $6.5 billion "monster" muni auction in late March—income and safety-hungry investors gobbled up a whopping 62% more bonds than the state had originally expected to sell.
The 10-year bond was offering a particularly robust 4.9% tax-free yield, a full 2.1% more than 10-year Treasuries.
For investors in the 35% tax bracket, a 4.9% tax-free yield represents a 7.5% taxable equivalent yield. No wonder yield-starved and equity-weary investors stormed the gates.
Muni Madness Has Begun
So what's going on? It's real simple: Income-hungry investors have been quietly snapping up tax-free municipal bond ETFs at an ever-increasing pace since last fall.
Early-bird contrarians, who loaded up on munis at their deepest discounts in October and December, have already scored 15-20% gains.
As a result, many seasoned bond pros believe income investors should start loading up on municipals right now. The average prices for the 17 tax-free bond ETFs are still trading 9.6% below their 2008 peak values and present some fairly remarkable opportunities.
For example, PZA and MLN are priced 14.6% and 17.8% below their respective 2008 highs. Furthermore, they offer very attractive tax-exempt yields of 4.86% and 5.12% currently.
Munis Offering Mouth-Watering Yields
So how valuable is a 5% tax-exempt yield? Most investors just link to a "taxable-equivalent yield calculator" to do the math. (An easy-to-use example is the one supplied by Vanguard here.)
But you can easily compute the number yourself. Here is the taxable-equivalent yield formula:
(Inverse of your tax bracket)
Say for example you're in the top 35% Federal ordinary income tax bracket (soon to be 39.6% under the new Obama tax plan) and want to purchase a 5% tax-free ETF. Here is the calculation:
5.0 = 5.0 = 7.69% taxable equivalent yield