Municipal bonds have long been a favorite of conservative income investors — particularly those retired or nearing retirement. After all, it’s hard to pass up tax-free interest income, and credit risk traditionally has been low on these state and local government IOUs. But because muni bonds require a fairly high minimum investment — about $5,000 — it can be difficult for smaller investors to diversify their portfolio. And high concentration in any single issue increases risk should the issuer default.
Enter muni-bond exchange-traded funds, which are baskets of municipal bonds that trade over a major exchange just like a stock, often tracking the performance of a major muni-bond index. ETFs offer several benefits over buying actual bonds: a smaller minimum investment, diversification and greater liquidity.
First, a few facts: Whether purchased individually or as shares of a diversified ETF, muni-bond investors are buying debt that a state, county or city has borrowed to fund new or existing public works or infrastructure projects like schools or highways.
There are two basic categories of municipal bonds: revenue bonds and general obligation bonds. Revenue bonds, which fund improvements in revenue-generating projects like airports or power plants, can repay investors only with cash created by those projects. The risk is higher because the financed project might not generate enough revenue on its own, or other events might impact the bonds’ value.
After American Airlines parent AMR (NYSE:AMR) filed for bankruptcy on Tuesday, the nearly $3 billion in special facilities bonds AMR sold through airports and municipalities for gate and hangar upgrades fell off a cliff, dropping as much as 68%, according to Bloomberg.
General obligation bonds are considered less risky because they’re backed by the municipality’s “full faith and credit” — meaning the governments can raise taxes to repay bondholders. Unfortunately for everyone, the economy has dealt a staggering blow to state and local governments’ tax revenues, and many are teetering on the brink.
Jefferson County, Ala. (which includes Birmingham) made the largest municipal bankruptcy filing in U.S. history on Nov. 10 after it failed to reach a deal with creditors to restructure more than $3 billion in debt, about one-third of which is general obligation bonds. Against that backdrop, its no news that municipal bonds — and municipal bond funds — have struggled lately.
Still, that doesn’t mean investors should bail on muni-bond investments. Although the congressional deficit-reduction supercommittee failed to agree on how to cut $1.2 trillion from the federal budget, it didn’t repeal munis’ tax-exempt status, either. And unlike the federal government, state and local entities don’t have the luxury of operating in the red, so most are making massive budget cuts to meet their debt obligations.
Because ETFs offer greater diversification and liquidity than individual munis, they’re a good choice for the income investor looking for exposure to the sector and its tax benefits while avoiding the greater up-front investment and potentially higher risk of a single bond issue. Here are four muni-bond ETFs to consider for the solid returns and tax advantages:
- Market Vectors Long Municipal Index (NYSE:MLN). This ETF seeks the price and yield performance of the Barclays Capital AMT-Free Long Continuous Municipal Index, which tracks the price movements of long bonds of 17 years or more. At $18.67, MLN has a market cap of $62.5 million, a net expense ratio of 0.24% and a current dividend yield of nearly 4.6%. Its year-to-date return is 13.2%.
- iShares S&P National AMT-Free Municipal Bond Fund (NYSE:MUB). This ETF seeks to achieve the price and yield performance of the S&P National AMT-Free Municipal Bond Index. At $106.26, MUB has a market cap of nearly $2.4 billion, a net expense ratio of 0.25% and a current dividend yield of 3.4%. Its year-to-date return is 10.3%.
- PowerShares Insured National Municipal Bond Portfolio (NYSE:PZA). The ETF is based on the BofA Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index, which tracks the performance of investment-grade, insured tax-exempt U.S. public debt. At $23.96, PZA has a market cap of $553 million, a net expense ratio of 0.28% and a current dividend yield of 4.7%. Its year-to-date return is 11.2%.
- Market Vectors High Yield Municipal Index ETF (NYSE:HYD). This ETF aims to replicate the price and yield performance of the Barclays Capital Municipal Custom High Yield Composite Index. The fund seeks a 75% weight in non-investment grade municipal bonds and a 25% weight in Baa/BBB-rated investment grade municipal bonds. At $29.47, HYD has a market cap of $292 million, and a higher net expense ratio of 0.35%. However, its current dividend yield comes in at a whopping 6%. HYD’s year-to-date return is 9.3%.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned stocks.