From the July 2009 issue of Research Magazine • Subscribe!

Surviving the Muni Storm

The total U.S. muni bond market is worth $2.7 trillion; several key muni-bond ETFs (MUB, PRB, PVI, CXA and NYF) are profiled below.

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, muni bonds have been one of the safest bond investments around. But the fiscal condition of state and local governments is rapidly deteriorating. If you want to successfully navigate the storm, it's crucial that you know what to do.

According to the Center on Budget and Policy Priorities, over the next two fiscal years a startling 47 states are likely to confront an aggregate budget shortfall of $350 billion. State tax collections during the first quarter fell 12.6 percent or about $20 billion, according to the Nelson A. Rockefeller Institute of Government at the State University of New York. Unlike the U.S. government, state and local governments can't just manipulate the interest rates or print more money.

The faltering financial status of local government is being reflected in other ways too.

Moody's, which misrated billions in garbage mortgage debt, assigned a negative financial outlook on the creditworthiness of all U.S. municipalities in April. 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 muni bond 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 muni bond investors, Ron Ryan, CEO of Ryan ALM, succinctly said, "trouble." Ryan was instrumental in the introduction of popular bond benchmarks like the Barclays U.S. Aggregate Bond Index (formerly the Lehman Brothers U.S. Aggregate Bond Index).

The total U.S. muni bond market is worth $2.7 trillion. Let's examine a few key muni bond ETFs (performance figures quoted are through the May 26 market close):

o iShares S&P National Municipal Bond Fund (MUB). With just over $1 billion in assets, MUB is one of the largest muni bond ETFs. The fund's performance and yield is linked to the S&P National Municipal Bond Index, which is composed of municipal bonds from state and local governments.

In order to be included within the fund's index, bonds must have minimum rating of BBB-minus by Standard & Poor's, Baa3 by Moody's or BBB-minus by Fitch. Each bond is denominated in 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 5.22 percent and currently carries a yield in the vicinity of 3.6 percent. In 2008, MUB declined 0.98 percent and the fund's annual expense ratio is 0.25 percent.

o Market Vectors Pre-Refunded Municipal Index ETF (PRB). This muni bond ETF was introduced in early February and is benchmarked to the Barclays Capital Municipal Pre-Refunded Treasury-Escrowed Index. The index is market-size weighted, and comprises pre-refunded and escrowed-to-maturity municipal securities backed by an escrow or trust account containing obligations issued or 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 one to 30 years. PRB's annual expense ratio is 0.24 percent.

o PowerShares VRDO Tax-Free Weekly Portfolio ETF (PVI). This muni bond 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 0.46 percent and currently carries a yield in the vicinity of 2.9 percent. In 2008, PVI gained 0.44 percent and the fund's annual expense ratio is 0.25 percent.

o SPDR Barclays Capital California Municipal Bond ETF (CXA). This 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 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 6.73 percent and currently carries a yield in the vicinity of 4.2 percent. In 2008, CXA declined 3.5 percent and the fund's annual expense ratio is 0.20 percent.

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

Year-to-date, NYF has gained 6.13 percent and currently carries a yield in the vicinity of 3.8 percent. In 2008, NYF declined 2.02 percent and the fund's annual expense ratio is 0.25 percent.

Active Underperformers

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 states and cities. This time around things are indeed different.

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

According to Standard & Poor's latest research (the firm gives a regular scorecard on S&P indices versus active funds), over the past five years just over 95 percent of actively managed national muni bond 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 percent of active funds were licked by S&P muni indices. Don't get victimized by eager bond fund managers that routinely underperform.

Opaque Market

The municipal bond market is not known for its financial transparency. This is due, in part, to a lack of rigorous oversight. The Securities and Exchange Commission is prevented from regulating the muni market because of the Tower Amendment and other restrictions imposed by Congress. In a recent Wall Street Journal piece, Arthur Levitt, former chairman of the SEC, observed "There is no central regulator over municipal issuers other than the Internal Revenue Service, which limits itself to a narrow band of concerns."

Are large-scale municipal bond defaults possible? While the answer to this question is not known, Levitt argues for better disclosure rules that could help investors to decipher risk. One of the chief concerns relates to whether the rating agencies are rigorous and uniform in their assignment of muni bond debt.

Financial Squeeze

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. In May, California voters rejected a plan to balance the state's budget, which could widen from $15 billion deficit to $21 billion. The state's unmanageable debt load could become the rest of the nation's headache. California Treasurer Bill Lockyer has already petitioned Treasury Secretary Timothy Geithner for the federal government's help in becoming a buyer of short-term loans if the state defaults. Are fiscally foundering states the next phase of the federal government's bailouts?

Multiple Strategy

Advisors should be particularly concerned with rising defaults of muni bonds located in economically depressed U.S. regions. "One way to mitigate the risks of single-credit selection would be a more diversified approach, focusing on multiple issuers across a broad spectrum of sectors," said Glenn Smith, director of ETF Sales at Van Eck Global. "Given the current concerns about credit risk, the diversification benefits of a national municipal approach may outweigh the state and local tax benefits inherent in a state-specific approach."

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Ron DeLegge is the San Diego-based publisher and editor of ETFguide.com and the radio host of the "Index Investing Show," which is broadcast nationally on Saturday afternoons and can be heard online at www.indexshow.com. Ron served as an investment and financial advisor for 11 years.

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