A Safer Strategy for Munis

02/13/2014 9:00 am EST

Focus: BONDS

Todd Rosenbluth

Senior Director of ETF & Mutual Fund Research, CFRA Research

We believe the municipal bond market's fundamentals are improving, and that there are ETFs that give investors the opportunity to limit their exposure to rising rates, suggests Todd Rosenbluth, S&P Capital IQ director of ETF Research in The Outlook.

There are several positive signs in the municipal bond market according to J.R. Rieger, Vice President of Fixed Income Indices for S&P Dow Jones Indices.

Home prices, as tracked by the S&P Case Shiller US National Home Prices Index, have recovered from their early 2009 level and are back to where they were in mid-2004.

Meanwhile, many municipalities run balanced budgets and, through the second quarter of 2013, there were positive trends in state and local government tax collections.

Lastly, despite the shock of Detroit's bankruptcy filing, municipal bond defaults, among the 2,848 deals in the S&P Municipal Bond High Yield Index, occurred less frequently in 2013 than in 2012 or 2011; just 23 issues, or 0.81%, defaulted, down from 1.0% and 1.5%, respectively, in the prior two years.

This compares favorably to the 2.1% default rate among speculative grade corporate bonds, according to Standard & Poor's Ratings Services. (S&P Capital IQ operates independently from S&P Dow Jones Indices and Standard & Poor's Ratings Services.)

Defaults are less common in municipal bonds because credit quality tends to be stronger. Indeed, when we look at iShares National AMT-Free Muni Bond ETF (MUB), which tracks the S&P National AMT-Free Municipal Bond Index and is the largest muni ETF, we find 50% of the assets are in bonds rated AA and just 2% are rated BBB.

Meanwhile, the SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB), which tracks the aforementioned S&P High Yield Index, has approximately 46% of assets with an investment-grade rating. We think this helps alleviate some of the credit quality concerns for muni bond ETF investors.

However, the 10-year Treasury yield rose in 2013 amid expectations that the Federal Reserve would begin to taper, or scale back, its bond buying program.

We think the issue of potentially higher rates remains a concern for 2014. Indeed, these portfolios have durations that are quite high relative to taxable bond equivalents, making them more prone to suffer, if rates indeed climb in 2014.

Fortunately, there are some short-term muni ETFs to choose from. The largest is SPDR Nuveen Barclays Short-Term Muni Bond (SHM). About 65% of the bonds inside have a AA rating, with most of the remaining ones having a AAA rating.

Two others are iShares Short-Term National AMT-Free Municipal Bond ETF (SUB) and Market Vectors Short Municipal Index ETF (SMB).

The Market Vectors fund, not surprisingly, has more A bond exposure and less AA exposure than the iShares fund. However, both have lower average durations than iShares National AMT-Free Muni Bond and thus might appeal to investors concerned about the impact of higher rates.

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