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Dangers and Opportunities in Muni Bond ETFs Crash

Interest-Rates / Exchange Traded Funds Dec 23, 2010 - 08:58 AM GMT

By: Ron_Rowland

Interest-Rates

Best Financial Markets Analysis ArticleBonds of all kinds took a beating over the last few months — ever since Ben Bernanke began hinting he would launch another “quantitative easing” money-printing program.

Ben was true to his word. And the QE2 program was announced on November 3. Interest rates shot up in the following weeks. That was bad news both for individual bondholders and bond exchange traded funds (ETFs).


Look at these results for the period 11/2 through 12/15 …

  • iShares Barclays 7-10 Year Treasury (IEF): Down 6.1 percent
  • iShares Barclays 10-20 Year Treasury (TLH): Down 7.7 percent
  • iShares Barclays 20+ Year Treasury (TLT): Down 9.6 percent
  • Vanguard Extended Duration Treasury ETF (EDV): Down 13.2 percent

If we move the start date back a few months to August 31, the losses total 15.1 percent for TLT and a whopping 23.4 percent for EDV.

Just imagine: Investors lost nearly a quarter of their money in less than four months in what many believe to be the world’s safest investment — U.S. Treasury bonds.

Stocks were going up during this same period. The S&P 500 with dividends gained 3.7 percent since early November and more than 18 percent since the end of August. So if you had a balanced portfolio, you may have still done ok. Yet losses like these are always disturbing.

This leaves income-oriented investors in a tough spot. Stocks can provide some yield via dividends, but your principal is far from safe. The only way to get a decent income from bonds is to go way out on the maturity scale — and we’ve seen that those funds are subject to huge volatility as well.

Given all this, it’s hard to blame investors who simply leave their money in cash or short-term CDs and T-bills. The yield may be close to zero, but at least the money is safe.

I think there is another way, though. It’s not risk-free by any means — but we can never completely eliminate risk. The key is to have a balance between risk and reward.

By this standard, Treasury bonds are not very attractive right now. Investors know that Congress is addicted to spending and debt. Political forces ensure that this won’t change for a long time, if ever.

As the federal government sinks closer and closer toward financial insanity, I think other types of bonds will gain attention from big-time investors. Highest-quality corporates, foreign governments, municipals — anything that doesn’t originate in Washington D.C. is starting to look relatively better to me.

I’m especially interested in the long-term prospects of municipal bond ETFs, for these reasons:

Reason #1— State and local leaders are getting the message

Unlike the federal government, they don’t have the luxury of being able to print more money. They are required by law to balance their books.

State legislatures and city councils are being forced to make hard decisions: Cutting services, getting tough with public employee unions, raising property taxes. It’s a long, slow process. It hits their local economies hard. But, in the long run, they are on the right track.

Reason #2— Many muni bonds are tied to real assets

“Revenue bonds” are based on the income from public facilities like toll roads, airports, and hospitals. Yes, the income isn’t guaranteed, but these bonds aren’t just vague promises. There is something real behind them.

Municipal revenue bonds are tied to real assets like toll roads.
Municipal revenue bonds are tied to real assets like toll roads.

Reason #3— Muni bond income is tax-free

That’s right — you don’t have to pay federal income tax on your interest from these bonds. You might have to pay state income tax, but that’s minor by comparison.

I don’t recommend individual muni bonds. Investors need diversification as well as liquidity, quality and low costs. ETFs are just the ticket.

Here are some ETFs that provide broad-based, national coverage with good quality.

  • iShares S&P National AMT-Free Muni (MUB)
  • SPDR Nuveen Barclays Municipal Bond (TFI)
  • PowerShares Insured National Muni Bond (PZA)

In addition, earlier this year iShares introduced a new line of ETFs that I think are very interesting and innovative. They give you the diversification of an ETF while preserving the maturity characteristics of individual bonds. They do this by combining bonds that all mature in a certain year. So if you’re concerned about the volatility of long-term bonds, you can target shorter maturities …

  • iShares 2012 S&P AMT-Free Muni Series (MUAA)
  • iShares 2013 S&P AMT-Free Muni Series (MUAB)
  • iShares 2014 S&P AMT-Free Muni Series (MUAC)
  • iShares 2015 S&P AMT-Free Muni Series (MUAD)
  • iShares 2016 S&P AMT-Free Muni Series (MUAE)
  • iShares 2017 S&P AMT-Free Muni Series (MUAF)

These are great for planning ahead or creating laddered portfolios …

Say you know you’ll have a specific obligation, like a college tuition payment, due at the end of 2014. Invest in MUAC and you’ll have a portfolio of tax-free bonds that mature just in time to make your payment. You can also set up a laddered portfolio for annual distributions.

The biggest downside with these new ETFs is that most investors aren’t aware they exist, so trading volume is extremely low. Be sure to use a limit order and be patient with your purchase.

They’ve been falling recently and could decline further. But I think they’re likely to outperform Treasury bonds over the next year and perhaps longer.

Best wishes,

Ron

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