Are Muni Bond ETFs Worth the Risks?

Yes ... but right now, you might want to reduce your exposure

   
Are Muni Bond ETFs Worth the Risks?

Detroit has put municipal bonds back in the headlines.

stockoftheweek Are Muni Bond ETFs Worth the Risks?The city declared last week that it will be unable to make payments on a portion of its debt, and has asked bond holders to be repaid less than 10 cents on the dollar. While defaults on muni bonds are rare, there have been several high-profile instances of insolvent municipalities or debt restructuring demands during the past several years that have shaken investors’ confidence in these securities.

In addition, the recent rise in interest rates has caught many fixed-income holders off guard as the price of their bonds has receded.

So is it time to throw in the towel on muni bonds, or should investors ride out the volatility?

A quick look at a chart of the iShares National AMT-Free Muni Bond ETF (MUB) shows just how volatile the environment has been for municipal bonds over the last year. This ETF currently has exposure to 2,376 individual bonds, although California, New York and Texas account for nearly 50% of its holdings. It has total net assets of more than $3.5 billion with a 0.25% expense ratio and six-year average duration.

mub Are Muni Bond ETFs Worth the Risks?

MUB has a 30-day SEC yield of 1.92%, which iShares has calculated to a tax-equivalent yield of 3.39%. Tax-equivalent yield is used to compare the difference between the yield on a taxable bond vs. that of a tax-free bond. In my opinion, that yield is exceptionally low for the type of volatility and whipsaws that this investment has produced over the last 12 months.

So far this year, MUB has a total return of -2.18%, while an active core strategy such as the PIMCO Total Return ETF (BOND) is down just -0.64% over that same time period. Some would argue that comparing MUB to BOND is like comparing apples to oranges, as most muni bond investors are focused on tax-free income. However, I think it is important to point out viable fixed-income alternatives even if they aren’t tax-free — because at the end of the day what matters most is total return.

In my analysis of the individual holdings in MUB, I was able to find several small allocations to Detroit municipal bonds. However, the position sizes were so minimal as to have very little impact on the price of the fund. A default or restructuring of that debt would more than likely be trumped by significant price movement in the three key states that dominate the holdings. This is one of the benefits of owning a large, diversified ETF instead of individual securities that might be susceptible to additional credit risk.

How to Play the Municipal Bond Sector

If you have exposure to broad-based municipal bond funds, you have most likely already endured the brunt of this move in interest rates and price sensitivity. I would continue to hold these positions but look to reduce exposure on any rallies so you do not overweight your portfolio in this underperforming asset class.

In addition, you might want to consider shortening the duration of your muni portfolio to funds such as the iShares Short-Term National AMT-Free Muni Bond ETF (SUB) or SPDR Nuveen Barclays Short Term Municipal Bond ETF (SHM), which offer smaller price fluctuations, though they also have lower yields. Ultimately, the impact of rising interest rates will continue to put downward pressure on fixed-income ETFs with higher average durations.

Lastly, I would point out that investors who want more focused exposure to a specific state such as California or New York might get additional benefit from dual federal and state tax-free status. ETFs for these states include: iShares California AMT-Free Muni Bond ETF (CMF), SPDR Nuveen Barclays New York Municipal Bond ETF (CXA), iShares New York AMT-Free Muni Bond ETF (NYF), or SPDR Nuveen Barclays New York Municipal Bond ETF (INY).

David Fabian is Managing Partner and Chief Operations Officer of Fabian Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. To get more investor insights from Fabian Capital, visit their blog.


Article printed from InvestorPlace Media, http://investorplace.com/2013/06/are-muni-bond-etfs-worth-the-risks/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.