The municipal bond market has been hard hit this year as investors
pulled their capital out of these bonds for most of the year. The
Fed’s taper threat and the resultant increase in interest rates
since late May largely prompted investors to avoid these plays
(read: 3 Ways to Play Rising Rates with Inverse Treasury ETFs).
This, along with Detroit's bankruptcy filing as well as the
concerns on the financial soundness of Puerto Rico as well as state
and local governments, weighed heavily on the safety of the muni
debt market, thereby resulting in a heavy sell-off in this corner
of the market. In fact, the U.S. municipal bond market reached a
four-year low in the third quarter, shrinking to $3.69 trillion
from $3.72 trillion in the second quarter.
However, the situation will likely rebound in 2014 with Illinois on
the verge of a pension reform and reduced pension payments under
the Detroit bankruptcy protection. Given these improving
fundamentals and bullish sentiments, municipal bonds look
attractive and cheap at current levels.
Trends Look Promising
Detroit, with its $18 billion in debt, is the largest bankrupt
municipality in the nation’s history after Federal Judge Steven W.
Rhodes consented to the protection earlier this month. Under the
bankruptcy protection, the city could impose cuts on pension plans
(read: Municipal Bond ETFs to Watch After Detroit Bankruptcy).
This decision is not only good news for Detroit, but it also paves
way for reduced pension funding to other financially troubled
cities in California, Illinois and Pennsylvania. This implies a
clear win for municipal bondholders in a number of states.
Further, as the U.S. economy is showing increased confidence on a
recovering housing market, healing labor market and strong retail
sales data, credit quality of municipal bonds would improve, and
the default rate would decline drastically in the coming
months.
Though the Fed has begun to scale back the monetary stimulus, it is
also still committed to keep the interest rates near zero for the
near term. This could give a boost to the municipal bonds assuming
rates find a stable level (read: 3 Covered Call ETFs to Pump Up
Your Income).
Moreover, with U.S. tax rates likely on the rise in the near
future, the demand for municipal bonds will continue to increase,
especially with investors in high income tax brackets. This is
because these securities pay interest that is free from federal
income tax, making them excellent choices for those looking to
reduce their tax liabilities.
With that being said, investors seeking to tap the current
opportunity of beaten down municipal bond market could make a broad
play in this corner of the space with high quality bonds in their
portfolio, which has a relatively low risk of default.
For these investors, we have highlighted some of the most popular
muni ETFs, any of which could be interesting picks as we approach
2014. These products have a decent Zacks ETF Rank of 3 or ‘Hold’
rating (see: all the Municipal Bonds ETFs here):
iShares National AMT-Free Muni Bond ETF
(MUB)
This fund provides exposure to the investment-grade segment of the
U.S. municipal bond market, holding a large basket of 2,191
municipal bonds across a number of states and sectors. California
munis take the top spot with nearly 22% of total assets, closely
followed by New York at 19%.
The product focuses on mid and long-term securities with average
maturity of 6.82 years and effective duration of 7.26 years. MUB is
the largest and most popular product in the national munis space
with AUM of over $3 billion and solid average daily volume of more
than 270,000 shares. The ETF charges 25 bps in fees per year from
investors and is down nearly 3.3% in the year-to-date time
frame.
SPDR Nuveen Barclays Municipal Bond ETF
(TFI)
This product is also a popular choice for muni bond investing, as
it has just less than a billion dollars in assets and sees nearly
370,000 shares in volume a day. Holding 418 securities in its
basket, the fund is spread across a variety of states with New York
and California munis making up for a combined 36% share (read:
STPP: A Great Bond ETF For Rising Rates).
The product focuses on municipal bond carrying a rating of Aa and
higher, suggesting low default risk. The ETF is slightly skewed
toward the longer-term maturity securities, resulting in average
maturity of 12.43 years and modified duration of 8.60 years.
Expense ratio came in at 0.30%. TFI has lost nearly 4% this year so
far.
PowerShares Insured National Municipal Bond Fund
(PZA)
This product focuses on the insured market of U.S. municipal bonds
by tracking the BofA Merrill Lynch National Insured Long-Term Core
Plus Municipal Securities Index. The fund has amassed $564.1
million in its asset base while charging 28 bps in annual fees.
Volume is solid as it exchanges nearly 310,000 shares per day.
With 164 securities in its basket, the fund is heavily tilted
toward long-term securities as those that mature in at least 20
years account for roughly 77% of the assets. This results in higher
effective duration of 9.60 years and effective maturity of 22.84
years.
In term of credit quality, PZA focuses on high quality bonds with
ratings of AA and higher. The ETF lost nearly 7% in the
year-to-date time frame.
Bottom Line
The municipal bond market is heading toward its first annual
negative returns since the financial crisis given the current
higher interest rate and credit risks. However, the recent positive
developments in Detroit and Illinois make the investment case in
this market attractive even with the start of the taper.
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ISHARS-NAMTF (MUB): ETF Research Reports
PWRSH-IN NAT MB (PZA): ETF Research Reports
SPDR-NB MUNI BD (TFI): ETF Research Reports
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