Profiting from the Coming Municipal Bond Hurricane
Ron DeLegge, Editor
April 22, 2009

SAN DIEGO (ETFguide.com) – The next corner of the bond market that looks poised for a storm of epic proportions is the usually quiet and tame municipal bond market. Historically, munibonds have been one of the safest bond investments around. But the fiscal condition of local governments is rapidly deteriorating. If you want to successfully navigate the storm, it’s crucial that you know a few basic facts.

According to the Center of Budget and Policy Priorities, over the next two fiscal years a whopping 47 states are likely to confront an aggregate budget shortfall of $350 billion. Unlike the U.S. government, state and local governments can’t just manipulate the interest rates they pay on debt or print more money.

Moody’s, which mis-rated billions in garbage mortgage debt, two weeks ago assigned a negative financial outlook on the creditworthiness of all U.S. municipalities. While it’s true that debt rating agencies don’t hold the same level of credibility or respect they once had, it would be fool-hearted (not to mention bone-headed) for munibond investors to ignore the  warning signs.

After being asked in a recent radio interview on the Index Investing Show what the debt downgrades would mean for munibond investors, Ron Ryan, CEO of Ryan ALM succinctly said, “Trouble.”

Municipal bonds are debt obligations issued by states and local government to finance various projects and services for the benefit of their communities.

Let’s examine a few key munibond ETFs.

iShares S&P National Municipal Bond Fund (NYSEArca: MUB)
With just over $1 billion in assets, MUB is one of the largest munibond ETFs. The fund’s performance and yield is linked to the S&P National Municipal Bond Index which is comprised of municipal bonds from U.S. state, city and local governments.

In order to be included within the fund’s index, bonds must have minimum rating of BBB- by Standard & Poor's, Baa3 by Moody's, or BBB- by Fitch. Each bond is denominated in U.S. Dollars and must have no less than $50 million in outstanding par amount. This index is market value weighted and holdings are updated on the last business day of each month. Munis from Puerto Rico, Guam, and U.S. Virgin Island territories are also included.

Year-to-date, MUB has gained 2.8% and currently carries a yield in the vicinity of 3.6%. In 2008, MUB declined 0.98% and the fund’s annual expense ratio is 0.25%. 

Market Vectors Pre-Refunded Municipal Index ETF (NYSEArca: PRB)
This particular munibond ETF was just introduced in early February and is benchmarked to the Barclays Capital Municipal Pre-Refunded–Treasury-Escrowed Index. The index is market-size weighted comprised of pre-refunded and escrowed-to-maturity municipal securities backed by an escrow or trust account containing obligations that are directly issued or unconditionally guaranteed by the U.S. government.

The fund’s index excludes pre-refunded bonds backed by agency securities or third-party investments such as CDs. Bond maturities generally range from 1-to-30 years. PRB’s annual expense ratio is 0.24%.

PowerShares VRDO Tax-Free Weekly Portfolio ETF (NYSEArca: PVI)
This munibond ETF is benchmarked to the Thomson Municipal Market Data VRDO Index. The index is designed to track the performance of a pool of short-term, tax-exempt Variable Rate Demand Obligations (VRDOs) issued by U.S. municipalities. VRDOs are generally high-quality, floating-rate bonds that provide investors with tax-exempt income in a short-term time frame. VRDOs are always purchased at par. When they are put back to an investment dealer, the investor receives par plus accrued interest. Yields are generally reset on a weekly basis.

Year-to-date, PVI has gained 0.35% and currently carries a yield in the vicinity of 2.9%. In 2008, PVI gained 3.36% and the fund’s annual expense ratio is 0.25%. 

SPDR Barclays Capital California Municipal Bond ETF (NYSEArca: CXA)
This municipal bond ETF seeks investment results that correspond to the performance, before fees and expenses, of the Barclays Capital Managed Money Municipal California Index. The index tracks publicly traded California municipal bonds that cover the U.S. dollar denominated California tax exempt bond market, including state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

Year-to-date, CXA has gained 5.54% and currently carries a yield in the vicinity of 4.2%. In 2008, CXA declined 3.5% and the fund’s annual expense ratio is 0.20%. 

iShares S&P New York Municipal Bond ETF (NYSEArca: NYF)
This munibond ETF follows the S&P New York Municipal Bond Index. The index measures the performance of the investment grade segment of the New York municipal bond market and is a subset of the S&P National Municipal Bond Index which comprised of municipal bonds issued in the state of New York. Each bond must have a rating of least BBB- by Standard & Poor’s and must have a minimum par amount outstanding of $50 million. In addition, each bond must have a minimum term to maturity and/or pre-refunded or call date greater than or equal to one calendar month to be included in the index. The index is market value weighted. The securities are updated on the last business day of each month.

Year-to-date, NYF has gained 6.12% and currently carries a yield in the vicinity of 3.8%. In 2008, NYF declined 2.02% and the fund’s annual expense ratio is 0.25%. 

Active Munibond Funds Underperform
Trouble in the municipal bond market is accelerating. It’s imperative that bond investors have a realistic view of the severe fiscal conditions confronting America’s cities and states. This is not the time for apathy.

Trusting in bond fund managers to help you navigate the munibond minefield has not been particularly profitable. Not only do most actively managed munibond funds charge higher fees compared to index ETFs, but they are notorious for underperforming.

According to Standard & Poor’s research, over the past 5 years just over 95% of actively managed national munibond funds underperformed compared to the S&P National Munibond Index. The numbers were even worse for state specific muni-funds like California and New York where 100% of active funds were licked by S&P muni indices. Don’t get victimized by eager bond fund managers that routinely underperform. 

The Financial Squeeze
The state of California’s situation is a textbook example of the credit crisis. The state’s access to the capital markets was virtually shut down in the second half of 2008 and into the early part of this year. While the state will re-enter the markets following the enactment of a new budget package, it’s not yet known if California has maxed out its borrowing capacity. Several elements of California’s budget package, like $5 billion more of borrowing, require voter approval which has been placed on a special election ballot slated for vote on May 19th, 2009.

The April 21st edition of the Wall Street Journal pointed out how cash-strapped cities around the country are now hiring private guards in the place of uniformed police to save money. The city of Chicago now permits hired guards to write traffic tickets. Facing severe budget shortfalls, the city of Oakland, CA is assigning the responsibility of public safety to more and more privately contracted armed guards. What’s next?

Your Munibond Strategy
In the Weekly Pick section of our ETF Profit Strategy Newsletter we warned, “Investors should be particularly concerned with rising defaults of munibonds located in economically depressed U.S. regions.” Some examples include California, Florida, and Michigan but there are many others. People that stubbornly invest in individual municipal bonds in the hardest hit localities will probably fair the worst. Overlooking credit risk because you want the tax-break of investing in local bonds from your state is not advisable.

If you own municipal bonds, you owe it to yourself to revisit your investment strategy. Do you own bonds or a bond fund that are concentrated in municipalities on the brink of bankruptcy? How should you play the munibond hurricane? Find out which municipal bond ETF we highlighted to our subscribers as the best way to tackle the pothole infested munibond market.

Performance figures quoted through April 21st market close.