Not Frightened of Municipal Bond Defaults? Try ETFs

Morningstar analyst reminds investors not every municipality is Chicago

Fixed income of all kinds has fallen off a cliff since the Fed’s announcement of quantitative easing on November 3, and the 60 Minutes interview with Meredith Whitney last week has given municipal bonds an added push.

Warning on the popular CBS news program about what she called “the largest threat to the U.S. economy” since the housing real estate market collapse, the bank analyst—who correctly forecast the ruination of banks resulting from soured real estate loans—may have overstated her case, according to some critics.

As spooked retail investors unload their muni bonds, we turned to Morningstar’s Director of ETF Research Scott Burns (left) for the non-catastrophic view on investing in munis, and advice for those who might actually want to buy munis.

Burns is not bullish on munis. “My personal prediction is we’re in for a bumpy ride,” he makes clear, but also argues that “the ferocity of the selloff in light of no actual news was a mismatch."

Advisors seeking muni bond exposure for their clients should look closely at ETFs, he says. Burns calls iShares S&P National AMT-Free Municipal Bond Fund (MUB) a good starting place for broad based muni exposure. And he’s “shocked” that iShares target-date muni ETFs (S&P AMT-Free Municipal Series 2012-2017) haven’t been more popular with advisors seeking more targeted muni investing, given their diversification and liquidity advantages over individual issues.

Another key advantage of ETFs over mutual funds is the ability to buy them at market price, which Morningstar research shows has been a better indicator of value than mutual fund NAV-based pricing. Arbitrageurs at Goldman Sachs and other sophisticated institutional investors routinely take advantage of these differences between market and NAV pricing.

While even ETF muni investors should expect bumps, Burns believes investors can distinguish between ordinary municipalities and his home town and home state. “I live in a third-world country,” he laments. “The worst of the worse will have to pay the price. Not everywhere is Chicago or Illinois.”

“[Whitney is] so deep into the housing crisis that she can’t see her way out of it now. It’ll affect the Illinois State Teacher’s Pension,” while investments in better managed municipalities should perform as expected,” he argues.

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