After witnessing an impressive run-up through the first three quarters of the year, more and more investors are now expressing concern over a bubble in bond markets. Reaction to the recent announcement of another round of QE has skewed towards the negative, as economists both in the U.S. and around the globe have predicted that the Fed’s most recent initiative will only dig a deeper hole. Much of the attention has focused on Treasury markets, where the Fed has become increasingly active and where concerns over paltry yields have sparked sell-offs in recent weeks.
While the turmoil in Treasury markets has been at the focus of speculation over a bond bubble, the recent tumble in the municipal bond market deserves some attention as well. This often-overlooked class of the bond market has long been a portfolio staple for current income-focused investors in high marginal tax brackets seeking to shield assets from heavy tax burdens. However, many are beginning to rethink the wisdom of this decision, as state budget situations become increasingly shaky and remain fraught with minimal opportunities for revenue growth or spending cuts [see 2010: Year Of The Bond ETF].
Chief among these issues is the ongoing budget crisis in California, the country’s most populous state. Outgoing Governor Arnold Schwarzenegger announced last week that he will call a special session of the state legislature on December 6th in order to tackle a budget deficit that some estimate will exceed $25 billion for the next fiscal year. In order to meet this shortfall in the near-term, investors look for the State to issue nearly $14 billion in new debt, an amount that is beginning to flood the muni market while investor demand remains tepid to say the least. According to the L.A. Times, analysts said that the market was facing a virtual “buyer’s strike” as investors now have simply stepped to the sidelines after last week’s slide saw yields soar thanks to lack of QE2 bond purchases in longer-term Treasury securities. “A lot of folks are saying this is the worst liquidity they’ve seen in two years,” said Joel Silva, a fund manager at iShares in San Francisco [also see Muni Bond ETFs: New York vs. California].
Another possible reason for this decline has been the looming end of the Build-America Bonds program, which has been a favorite of a variety of municipalities across the nation. Many organizations preferred to issue these taxable securities because the Federal government would pay the municipality a 35% credit of the interest payments. That subsidy from Washington helps to reduce borrowing costs while also keeping the bonds in the taxable market, which is far larger than its tax-free counterpart. Since the program’s extension is still up in the air, many cities and towns are racing to offer new bonds before the year ends and the program expires, further flooding the market with supply [see all the National Muni Bonds here].
These issues have conspired to send the municipal bond ETF market into a tailspin. By far the most popular ETF tracking the municipal bond market is the iShares S&P National Municipal Bond Fund (MUB), which has amassed over two billion in assets. The fund tracks the S&P National AMT-Free Municipal Bond Index which measures the performance of the investment grade segment of the U.S. municipal bond market. MUB offers allocations to over 1,000 different issues ensuring that it takes a wide swath of the muni bond market and isn’t overly impacted by any one region or time until maturity level. Due to this dispersion, MUB is often seen as a barometer for the entire muni bond market [also read Wide World Of Muni Bond ETFs].
Despite traditionally being one of the safest sectors of the fixed market, investor confidence in municipal bonds has waned in recent months as investors have grown increasingly concerned over the ability of many municipalities to repay their debts. The fund has now sunk by over 4.1% in the past week, which represents a huge plunge for the otherwise stable muni bond market. However, MUB was not even the worst performer in the muni bond sector; below we profile three of the hardest hit ETFs in the muni bond market [see all the Municipal Bond ETFs here].
- iShares S&P CA AMT Free Municipal Bond Fund (CMF): Down 5.5% over the past week. With a focus on the Californian muni bond market and crumbling fiscal situation in the Golden State, it isn’t surprising to see CMF on this list. The fund holds over 200 different bonds in total with a heavy overall focus on the medium section of the curve with high weightings going towards various purpose and utility bonds which combine to make up over 40% of the fund’s total bond holdings. In terms of credit quality, a plurality of bonds falls under the lower end of the investment grade spectrum with close to one-fourth going towards ‘A-’ rated and just 5.4% to ‘AAA’ securities.
- Market Vectors-Long Municipal Index ETF (MLN): Down 5.8% over the past week. This fund tracks the Barclays Capital AMT-Free Long Continuous Municipal Index which provides broad exposure to investment-grade municipal bonds with a nominal maturity of 17 years or more. Generally speaking, bonds that have longer until maturity are more sensitive to interest rate changes in the overall market. With the rates on comparable Treasurys skyrocketing, it should be no surprise that rates have also shot up for this long-term muni bond fund, sending prices sharply lower.
- SPDR Barclays Municipal Bond Fund (TFI): Down 4.3% over the past week. For investors seeking exposure to high quality, medium duration securities in the muni bond market, TFI is an interesting option. The fund offers exposure to over 300 muni bonds with an average modified adjusted duration of 9.7 years. The fund is heavily exposed to bonds in New York, California, and Texas, which all make up at least 11% of the fund, while also offering a near 5% allocation to bonds in Washington, Florida, and Illinois. Unlike many muni bond ETFs, this one only focuses in on the top quality issues; 75% of the fund’s holdings are rated ‘Aa’ while the remaining 25% are rated ‘Aaa’.
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Disclosure: No positions at time of writing.