Historically this asset class has delivered steady gains, but during the financial meltdown in October 2008 it dipped severely before recovering quickly. In November 2010 it dropped sharply again. Short-term the question is whether munis can snap back again. Long-term the question is whether volatility is here to stay.
We think munis are likely to snap back as they did before, especially given how little is needed to recover. Muni ETFs showed resilience during this recession. Munis have for solid stretches been as steady as Treasuries. It helps that munis are not a natural target for hot money. The core holder (directly or via funds) of the municipal bond is the high net income individual seeking relief from Federal taxes. This is a particularly patient investor.
A popular muni is the iShares S&P National Municipal Bond ETF (AMEX:MUB). In 2010 MUB saw a scary 6% to 7% drop but when compared to the previous years, such as in 2008, the drop becomes almost harmless.
Another popular medium-long duration (7-8 years) ETF is SPDR Lehman Municipal Bond ETF (NYSEArca:TFI).
Long-term, volatility should remain historically high as major forces tug at munis. On the one hand, states and municipal agencies are borrowing unprecedented sums to fund huge budget shortfalls and putting their credit ratings at risk. On the other hand, more investors are seeking stable income, and more investors are creeping into high tax brackets where munis have an edge against taxable bonds. These opposing forces are enormous and unpredictable and foreshadow increased volatility, although nothing like what we can expect from equities.
As with other bonds, munis face interest rate risk. The higher yield of longer maturities such as with Van Eck's Market Vectors Long Municipal ETF (NYSEArca: MLN) may be tempting, but we recommend holding it with sell limits in place. If what many call the bond bubble bursts and investors demand higher yield, a slide could be precipitous. Federal Reserve officials are pulling out all their tricks to lower interest rates with little effect. This is a warning sign.
Market Vectors Intermediate Municipal ETF (NYSEArca: ITM) would be less impacted from interest rate gyrations. True havens would be Market Vectors Short Municipal Bond ETF (NYSEArca: SMB) and iShares S&P Short Term National Municipal Bond Fund (AMEX: SUB) which sport average durations of just 2 years or so. Yields are paltry, however, at about 2%.
Another short duration alternative is the PowerShares VRDO Tax-Free Weekly Portfolio (NYSEArca:PVI). This more complex ETF achieves extremely short duration by contractually modifying long-duration bonds to reset their interest rates on a weekly basis. The principal is protected with a put feature and/or insurance. There is some risk in the soundness of the agreements themselves, but they survived 2008 fine so they appear solid. PVI pays around 3% yield and could be a smart choice for the sophisticated investor who is wary of interest rates but confident that credit markets will not disintegrate.
The muni market is rife with broker collusion and unconscionable fees for the individual investor. ETFs are an ideal way to remove these barriers because their professional managers avoid these traps. An added bonus is low fees. ETFs in municipal bonds seem to all have modest fees under about 0.30%.
Insured bonds normally give investors extra assurance, although insurance had a perverse effect in 2008 when insurance companies backing munis teetered. Panic selling of insured bonds made them cheaper than uninsured bonds. In 2011 and beyond PowerShares Insured National Municipal Bond Portfolio ETF (AMEX: PZA) will likely deliver protection and stability normally associated with insurance.
For California and New York residents, specialized ETFs buy bonds exclusively from one of those tax-happy states and allow shelter from state tax for their residents. These include:
Van Eck also provides these specialized products: