A Great Muni Bond Fund

09/18/2012 7:45 am EST

Focus: FUNDS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Popularity of municipal bond funds has escalated to a mania recently, but don't get caught up in the frenzy. Stick to this ETF and you'll be set, writes Benjamin Shepherd of Personal Finance.

According to the Investment Company Institute, municipal-bond funds have attracted more than $28 billion so far in 2012, marking their best year in almost two decades. Although muni bonds are typically a staid market, those inflows have occurred during a year that has experienced an uptick in muni-bond defaults.

As of late August 2012, muni-bond defaults have jumped to 0.5%, compared to 0.4% for all of 2011. Historically that’s a big spike, prompting the Federal Reserve Bank of New York to accuse the ratings agencies of underreporting defaults. The Internal Revenue Service has also jumped into the action, doubling its examinations of muni bonds to weed out noncompliant bonds.

Congress is even weighing in, as a surprising number of both Democrats and Republicans consider curtailing or outright eliminating the tax-exempt status of muni bonds.

Why are muni-bond investors, who epitomize risk adversity, so sanguine? A lack of better options plays a role, but the biggest driver of muni-bond fund inflows this year has been taxes.

Under the George W. Bush administration, most tax brackets were lowered and taxes on most dividends were set at 15%. As the “fiscal cliff” looms, the continued viability of those tax cuts remains in question. If Congress allows those reductions to lapse in 2013, most Americans will see an increase in their effective tax rates, with the tax on dividends jumping to 39.6% for top earners.

That makes tax-exempt muni bonds a very attractive proposition, particularly if you expect sizable Democratic gains in the November elections. The Democrats have made it very clear that if they retake complete control of Congress, they’ll push to raise taxes on high earners.

However, the odds of muni bonds losing their tax-exempt status are pretty long, especially since this political horse has been beaten to death. If municipals lose their favored tax treatment, localities would likely see their borrowing costs rise, pushing state and local tax rates higher. That would be a double-whammy for taxpayers, who would punish the politicians allowing it to happen.

For now, we’ll continue to take advantage of the favorable tax situation with our position in Market Vectors Intermediate Municipal (ITM) exchange traded fund.

Despite the ETF’s consistent gains over the past year, it continues to offer an attractive 2.9% yield. And it hasn’t stepped down the credit ladder to maintain its payout, boasting an average credit quality of AA.

The ETF’s expenses have also recently dropped to 0.24%, making it one of the most reasonably priced muni ETFs available. Buy Market Vectors Intermediate Municipal ETF.

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