Why Munis Make Sense

01/13/2010 10:36 am EST

Focus: BONDS

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

Doug Fabian, editor of Making Money Alert, says municipal bonds are a good place to be now, but you have to be selective, and he recommends an ETF.

With the Federal Reserve focused on keeping its zero-interest-rate policy intact as we enter 2010, conservative bond funds are gaining appeal. Such exchange traded funds (ETFs) offer a way to add balance to equity-leaning portfolios, and to produce income.

If inflation becomes a factor later in the year as the economy improves, bond funds may pull back. But for now, they offer a way to diversify your portfolio and to limit your risk, while giving you the opportunity for modest capital appreciation and dividends.

One fund that I like is the SPDR Barclays Capital Municipal Bond Fund ETF (NYSEArca: TFI). The fund offers the advantages that I just mentioned, while investing in bonds that are intended to correspond, before fees and expenses, to the price and yield performance of the Barclays Capital Municipal Managed Money Index (LMMITR). The ETF's strategy provides low portfolio turnover, accurate tracking, and relatively low costs.

I know many investors have heard about the horrendous budget deficit problems in my home state of California, as well as other cash-strapped states around the country. But I took a look at the top ten holdings of TFI and I noticed that the state bonds are in Massachusetts, New Jersey, Washington, and Nevada—not California.

In fact, a number of the fund's top ten holdings are municipal bonds tied to public transportation systems that should have a fairly consistent cash flow stream to support the debt payments. People still need to commute to get to work and to search for jobs, regardless of economic conditions. Discretionary travel could be curtailed during economic slowdowns, but probably not dramatically.

Keep in mind what you are buying with a municipal bond fund. If you want excitement in your life, a municipal bond fund is unlikely to provide it. They do, however, offer income in the form of dividend payments that certainly should beat anything your local bank is paying.

With munis, there is a risk to your capital if interest rates rise and bond prices fall. As a result, you may want to sell any position that you take if it becomes clear that inflation is coming back. Until then, you can beat the low interest rates that banks are paying on their deposits through this investment, while enjoying the potential of capital appreciation.

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