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.