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
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:
- The baby boomers are coming and they need more yield.
- Income tax rates will invariably go higher as the U.S. government seeks additional revenues to finance our burgeoning national debt.
- Tax-free municipal yields currently offer unusually high taxable-equivalent yields.
- 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: