Are Muni Bond ETFs In Trouble?

by on May 18, 2010 | ETFs Mentioned:

Municipal bonds are popular among investors in the highest tax brackets because unlike corporate bonds, the interest payments received are exempt from federal (and sometimes state) taxes. Moreover, because the issuers of such bonds are generally entities with the authority to levy taxes to make good on their debt payments, the level of perceived risk is low–especially when considering the attractive yields offered by many municipal bond issues.

But with cash-strapped state and local governments still struggling to turn their their fortunes around, stories of “sure thing” muni bond investments gone bad are popping up with increasing frequency. “It looked like the closest thing you could get to a sure bet — even in a city full of one-armed bandits,” writes Russell Pearlman. “The state of Nevada planned to build a sleek, automated monorail that would ferry millions of tourists up and down the famed Las Vegas Strip. And they were funding it by selling more than $600 million in municipal bonds — some of them paying a hefty 7.5 percent in interest.”

This “sure bet” went bust, as tourism to Sin City dropped off significantly and the nonprofit monorail agency filed for bankruptcy protection earlier this year. The Vegas economy has been hit harder than many areas of the country, but the ill-fated monorail debt issue isn’t the only instance of muni bonds going belly up (see Gaming ETF On A Hot Streak). According to SmartMoney, 201 municipal bond issuers have missed interest payments on $6 billion worth of bonds. That represents a significant increase from 162 to miss payments in 2008 and just 31 in 2007.

It may not be time to hit the panic button just yet, but many investors have begun cutting back their exposure to municipal bonds deemed to be risky in the current environment. Pearlman writes that “it doesn’t take a default for a municipal bond to lose value,” noting that the percentage of munis trading at a discount to face value has nearly doubled since before the recession (a statistic made even more startling when considering that interest rates continue to hover near record lows).

Muni Bond ETFs In Focus

Despite an uptick in defaults and default risk, investors continue to plow money into municipal bonds. Even at their elevated level, the default rates on munis remain well below those of corporate bonds, and the tax benefits are just as valuable as ever to many investors.

In recent years, municipal bond ETFs have seen tremendous growth; there are now 21 ETFs with more than $5 billion in assets in the National Munis ETFdb Category (which excludes California- and New York-specific muni ETFs). Below, we profile three ETFs offering unique exposure to the muni bond market:

Market Vectors High Yield Municipal Bond ETF (HYD)

While most muni-bond ETFs focus on investment grade issues, this ETF focuses on securities that fall lower down the credit spectrum. HYD tracks the Barclays Capital Municipal Custom High Yield Composite Index, a benchmark that has a 25% weighting in investment grade BBB bonds and 75% weighting in non-investment grade bonds. An x-ray look at HYD’s holdings shows that about three quarters of underlying assets have a coupon of 5% or greater, with about a quarter paying more than 5%.

iShares 2012 S&P AMT-Free Municipal Series (MUAA)

While most muni bond ETFs spread exposure across the various maturities, iShares recently launched a line of funds targeting specific end dates. As a look at MUAA’s holdings shows, this ETF focuses on debt issues maturing in 2010. iShares also offers muni bond ETFs focusing on debt maturing in 2013 (MUAB), 2014 (MUAC), 2015 (MUAD), 2016 (MUAE), and 2017 (MUAF). These funds are interesting for a couple reasons. First, they offer a way to build and fill maturity “ladders” within a portfolio. In addition, they will terminate around August 31 of the year in each ETF’s name, liquidating assets and returning principal to investors.

SPDR Nuveen Build America Bond ETF (BABS)

One of the newest additions to the ETF lineup, this ETF focuses on a corner of the muni bond market that has expanded rapidly since its introduction as part of the American Recovery and Reinvestment Act. BABS’ holdings consist of Build America Bonds, taxable municipal securities whose interest payments are partially subsidized by the federal government. Because the issuing municipality is only responsible for a portion (65%) of the interest payments, it allows local governments to issue debt with a reduced interest burden (read more about Build America Bonds).

Disclosure: No positions at time of writing.