Muni Madness: Yields Still Fat & Bargains Abound

April 06, 2009

 

Muni Rally Has Legs

Municipal ETF prices are continuing their rally that began in December 2008, already rising 3.7% in 2009.

A number of economists point to four distinct demographic and financial trends that should continue pushing investors toward tax-free municipals. Those trends bode well for municipal investors in the coming years:

  1. The baby boomers are coming and they need more yield.
  2. Income tax rates will invariably go higher as the U.S. government seeks additional revenues to finance our burgeoning national debt.
  3. Tax-free municipal yields currently offer unusually high taxable-equivalent yields.
  4. The unprecedented hoard of trillions of dollars in money market funds will sooner or later migrate to higher-yielding investments.

Beware Of The Free-Lunch Syndrome

More sanguine financial advisers are quick to point out that tax-free municipals are not without their own set of unique risks. The two greatest risks, they say, are default risks and interest-rate risks.

Although defaults on principal or interest payments among the top investment-grade general obligation municipals have been a paltry 0.3% over the past 20 years, the naysayers claim it's different this time.

In its March 16 issue, Forbes reminded us that before Standard & Poor's began rating municipals, 16% of munis defaulted during the Great Depression. In 1873, the default rate was a startling 23%.

The risk of rising interest rates presents another concern for muni investors as the U.S. government floats trillions of dollars of new Treasury and agency bonds in the coming years. Municipal bond prices, as do Treasury and corporate bond prices, move inversely to interest rates. If interest rates rise in the future, as many economists predict, bond prices will drop.

Gaining Some Protection

To reduce the impact of rising interest rates, most conservative municipal investors invest only in short- or intermediate-term municipal ETFs.

These could include SUB, SHM and SMB—all have portfolios with relatively short durations averaging three years or less. They offer tax-exempt yields of 1.95% to 2.83% currently.

The three intermediate municipal ETFs—ITM, MUB and TFI—have durations of 7-8 years and tax-free yields of 3.7% to 4.0%.

The reason durations and maturities are important is that the longer the durations of bond portfolios, the greater the risk of principal volatility—and potential losses.

To keep it safer from rising interest rates, keep maturities on the short- to intermediate side. (The average duration of each of the 17 muni ETFs can be found at their respective Web sites.)

Only one variable-rate municipal ETF exists: the PowerShares VRDO Tax-free Weekly Portfolio (NYSE: PVI). This unique municipal ETF resets its interest payments weekly and should offer increasing yields if interest rates do indeed rise in the coming years. This AA-rated ETF currently distributes 1.7% tax free, and its share price rarely fluctuates more than a few pennies weekly.

To protect themselves from default risk, municipal investors generally choose muni bond mutual funds over individual bonds, so default risks are diversified among dozens, if not hundreds, of different municipal bonds. The 17 currently available muni ETFs hold between 45 and 319 different municipal bonds in each fund—the average number of holdings is 110.

Municipal ETFs, because of their very low expense ratios averaging a mere 0.25% annually, are generally preferred over their actively managed, open-end municipal bond fund brethren (open-end funds often have considerably higher expense ratios).

For the ultimate in credit safety, look at the Market Vector's Pre-Refunded Municipal Index ETF (NYSE: PRB). This unique offering is the first ETF investing 100% in "pre-refunded" municipal bonds. (See related article here.) Pre-refunded municipals are issued to pay off existing, high-interest-rate bonds. These "pre-res," as municipal bond traders call them, are fully collateralized by U.S. Treasury securities, making them the only municipal bond class to be 100% fully guaranteed by the U.S. government. The yield of this AAA-rated muni ETF is a paltry 0.5%, but it is tax free and easily beats short-term U.S. Treasury bills.


Chance Carson is president of Alpine Strategies in Colorado Springs, Colo. He also serves as editor of www.AboutETFs.com, an educational Web site for retired investors. He welcomes comments and suggestions for future columns at:

[email protected].

 

 

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