Deal of a Lifetime in Muni Bond Investments?

by Darwin on February 8, 2009

It was mid-2008 when investing pundits and fund managers alike started to extol the virtues of municipal bond investments as perhaps the best investment of a generation given the relatively high yield and tax-favored status in relation to their low risk.  Since then, financial conditions have deteriorated even further, in some cases, driving the values of muni bond funds and ETFs substantially lower.  This begs the question as to whether now is finally the time to pull the trigger on these seldomly sexy investments or if the market has appropriately priced in municipality Armageddon.

Some Favorable Benefits of Muni Bonds and their related instruments:

  • Interest is usually exempt from federal income tax and from the income tax of the state in which the instruments are issued, although you’ll want to verify this one a case by case basis for either individual holdings or ETFs and Mutual Funds.  Therefore, you should consider the “tax-equivalent” return on munis as being much higher than say, the return on a taxable stock (i.e. depending on your tax bracket, you may only need say, a 7% return on your muni to beat the long run average of say 8.5% on stocks).
  • Yields are at historic highs, especially when considering the spread between munis and treasuries.
  • Our lawmakers seem insistent on continuously passing bailout after bailout – seeking to shore up near term economic prosperity at the expense of future generations.  This lessens the likelihood that states and municipalities will be foregone and have to default on their obligations.
  • Municipal bond ETFs and Mutual Funds are evolving, which spread
  • Correlation – while all asset classes were clobbered last year (except sporadic trading of oil and other commodities), during normal market conditions, munis are general low volatility with low correlation to the returns on common equities.

If these Municipal Bonds are such a great deal, why have the prices fallen so dramatically?

This stems from a number of reasons, one of which being that all asset classes fell at the same time, even gold last year (which is supposed to be the perfect hedge for such horrific occasions) due to the delveraging of massive institutional holders, hedge funds, sovereign funds, you name it.  Additionally, because many municipal bonds were insured by monoline insurers which were completely slammed by their bets on collateralized debt obligations (CDOs) last year, their credit ratings were impacted substantially, thus decreasing the attractiveness or assumed safety of the muni bonds they were insuring.  In short, the house of cards tumbled and took everything down with it, regardless of “true” risk since the perceived risk was off the charts for anything that wasn’t FDIC insured.

Ways to Invest for regular investors?

Municipal Bond ETFs –

PMF – Yield 8.5%(over 10% tax-equivalent!).  This is my vote for the Best Muni ETF because of its combination of a high yield with consistent returns since 2003…and diversification – it represents several states.  It pays monthly and has done so every month since 2003, including as recently as this January.

MAB – Yield 6.4%.  This Massachusetts ETF has also paid a steady monthly dividend for some time and actually just raised it late last year; not exactly the behavior you’d expect from an asset approaching insolvency.

HYD – High Yield Municipal ETF. This newly launched ETF from Van Eck Global is looking to take advantage of investor interest in high yield ETFs.  It has a respectable .35% expense ratio.  Note that only about a quarter of its holdings are investment grade and the rest are either not rated or are non investment grade.  Since it just launched, there is no routine dividend data available for review, but you can bet it will be a high yielder.  Just note the defaults by investment grade I listed below if considering in the future.

There’s More!  There are dozens of muni ETFs, too many to list here.  Many have sporadic dividend payments, have declining dividends or represent states that are at the epicenter of the real estate malaise (for instance, California and Florida have over a dozen each).

Other Considerations:

  • Municipal Bonds Do and Will Default – For this reason, I avoid trying to pick individual municipal bonds, but rather, seek out a diversified fund or ETF.
  • Don’t assume that because the yields are high and the dividend history looks attractive that the share price of an ETF or Fund can’t decline.  This is what we witnessed last year and only now, shares are beginning to recover.
  • Not all municipal bonds carry equivalent risk.  Higher yield generally means higher risk, since markets are efficient and for a given dollar investing in the muni category, you should assume investors efficiently assess comparative risk.  While the whole category looks attractive by historical standards, within the class, there are clearly some municipalities that investors are betting will default on their obligations.
  • For a comparison of historic default rates compared to Corporate Bonds, see the following table.

Cumulative Historic Default Rates (in percent)
————————————————————————
Moody’s                      S&P

Muni      Corp      Muni      Corp
————————————————————————
Aaa/AAA…………………….            0.00      0.52      0.00      0.60
Aa/AA………………………               0.06      0.52      0.00      1.50
A/A………………………..                 0.03      1.29      0.23      2.91
Baa/BBB…………………….             0.13      4.64      0.32     10.29
Ba/BB………………………               2.65     19.12      1.74     29.93
B/B………………………..                 11.86     43.34      8.48     53.72
Caa-C/CCC-C…………………        16.58     69.18     44.81     69.19
Investment Grade…………….     0.07      2.09      0.20      4.14
Non-Invest Grade…………….     4.29     31.37      7.37     42.35
All………………………..                  0.10      9.70      0.29     12.98

Other High Yield Investment Resources:

Ally Bank’s CD Yields are “Too High” and Prompt Complaints

14 High Yield Large Caps with Steady Dividends

15 High Yield Corporate Bonds

Beware the Allure of these 11% Yield Notes

Source: Wikipedia

Disclosure: Long PMF

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{ 5 comments… read them below or add one }

1 international bank transfers August 12, 2009 at 5:30 pm

Those are pretty good returns.. I wonder why more people haven’t talked these yet.
-Jack

[Reply]

2 Frugal Living September 6, 2009 at 1:17 pm

I am thinking of getting involved on this level with my cash but don’t think I am ready yet. Your returns look impressive but fear of the unknown is topping many like me I am sure.

Thanks and maybe one day I will give this a try.

Thanks,
Forest.
.-= Frugal Living´s last blog ..Once A Month Cooking Recipes =-.

[Reply]

3 The Biz of Life March 17, 2010 at 4:05 pm

I think you’re getting CEFs and ETFs mixed up. PMF, for example, is a leveraged CEF trading at a hefty premium to NAV as of this date, and fairly risky for a muni bond fund; expensive too at 1.42%. MAB is a CEF also.

[Reply]

Darwin Reply:

Yes, it is a CEF, which trades very much like an ETF save for the premium/discount. I’m not “discounting” (pun, sorry) the fact that it’s up more than SPY YTD, carries that consistent yield and also, CEFs often trade at premiums and discounts for months or even years on end. It’s not like one day a premium drops to fair value over night. But it is fair to point that out. Readers should investigate this premium/discount topic some more before investing. Thanks for your comment.

[Reply]

4 شات April 15, 2011 at 3:15 pm
5 دردشة April 26, 2012 at 5:27 pm

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