The Case For Municipal Bond ETFs In 2014

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December 22, 2013 11:36pm NYSE:MUB NYSE:PZA

etfs etfsThe municipal bond market has been hard hit this year as investors pulled their capital out of these bonds for most of the year. The Fed’s taper threat and the resultant increase in interest rates

since late May largely prompted investors to avoid these plays.

This, along with Detroit’s bankruptcy filing as well as the concerns on the financial soundness of Puerto Rico as well as state and local governments, weighed heavily on the safety of the muni debt market, thereby resulting in a heavy sell-off in this corner of the market. In fact, the U.S. municipal bond market reached a four-year low in the third quarter, shrinking to $3.69 trillion from $3.72 trillion in the second quarter.

However, the situation will likely rebound in 2014 with Illinois on the verge of a pension reform and reduced pension payments under the Detroit bankruptcy protection. Given these improving fundamentals and bullish sentiments, municipal bonds look attractive and cheap at current levels.

Trends Look Promising 

Detroit, with its $18 billion in debt, is the largest bankrupt municipality in the nation’s history after Federal Judge Steven W. Rhodes consented to the protection earlier this month. Under the bankruptcy protection, the city could impose cuts on pension plans (read: Municipal Bond ETFs to Watch After Detroit Bankruptcy).

This decision is not only good news for Detroit, but it also paves way for reduced pension funding to other financially troubled cities in California, Illinois and Pennsylvania. This implies a clear win for municipal bondholders in a number of states.

Further, as the U.S. economy is showing increased confidence on a recovering housing market, healing labor market and strong retail sales data, credit quality of municipal bonds would improve, and the default rate would decline drastically in the coming months.

Though the Fed has begun to scale back the monetary stimulus, it is also still committed to keep the interest rates near zero for the near term. This could give a boost to the municipal bonds assuming rates find a stable level.

Moreover, with U.S. tax rates likely on the rise in the near future, the demand for municipal bonds will continue to increase, especially with investors in high income tax brackets. This is because these securities pay interest that is free from federal income tax, making them excellent choices for those looking to reduce their tax liabilities.

With that being said, investors seeking to tap the current opportunity of beaten down municipal bond market could make a broad play in this corner of the space with high quality bonds in their portfolio, which has a relatively low risk of default.

For these investors, we have highlighted some of the most popular muni ETFs, any of which could be interesting picks as we approach 2014. These products have a decent Zacks ETF Rank of 3 or ‘Hold’ rating:

iShares National AMT-Free Muni Bond ETF (NYSEARCA:MUB)

This fund provides exposure to the investment-grade segment of the U.S. municipal bond market, holding a large basket of 2,191 municipal bonds across a number of states and sectors. California munis take the top spot with nearly 22% of total assets, closely followed by New York at 19%.

The product focuses on mid and long-term securities with average maturity of 6.82 years and effective duration of 7.26 years. MUB is the largest and most popular product in the national munis space with AUM of over $3 billion and solid average daily volume of more than 270,000 shares. The ETF charges 25 bps in fees per year from investors and is down nearly 3.3% in the year-to-date time frame.

SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA:TFI)

This product is also a popular choice for muni bond investing, as it has just less than a billion dollars in assets and sees nearly 370,000 shares in volume a day. Holding 418 securities in its basket, the fund is spread across a variety of states with New York and California munis making up for a combined 36% share (read:STPP: A Great Bond ETF For Rising Rates).

The product focuses on municipal bond carrying a rating of Aa and higher, suggesting low default risk. The ETF is slightly skewed toward the longer-term maturity securities, resulting in average maturity of 12.43 years and modified duration of 8.60 years. Expense ratio came in at 0.30%. TFI has lost nearly 4% this year so far.

PowerShares Insured National Municipal Bond Fund (NYSEARCA:PZA)

This product focuses on the insured market of U.S. municipal bonds by tracking the BofA Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index. The fund has amassed $564.1 million in its asset base while charging 28 bps in annual fees. Volume is solid as it exchanges nearly 310,000 shares per day.

With 164 securities in its basket, the fund is heavily tilted toward long-term securities as those that mature in at least 20 years account for roughly 77% of the assets. This results in higher effective duration of 9.60 years and effective maturity of 22.84 years.

In term of credit quality, PZA focuses on high quality bonds with ratings of AA and higher. The ETF lost nearly 7% in the year-to-date time frame.

Bottom Line

The municipal bond market is heading toward its first annual negative returns since the financial crisis given the current higher interest rate and credit risks. However, the recent positive developments in Detroit and Illinois make the investment case in this market attractive even with the start of the taper. 

This article is brought to you courtesy of Eric Dutram.

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