When the Federal Reserve slashed the federal funds target rate to a range of 0.0% to 0.25% in late 2008, most expected that the drastic measure would be temporary, and that interest rates would gradually climb higher. But nearly two years later, the U.S. economy continues to languish as job creation has failed to materialize and the debt burden continues to grow. With interest rates expected to remain near record lows for the foreseeable future, many investors who depend on their portfolios to deliver a current return have been forced to get creative in their hunt for attractive yield. For some that search has lead to junk bonds or debt of emerging market issuers, two asset classes that offer relatively attractive coupons in the current environment. Others have embraced high-yielding equities as a solution, pouring money into MLP ETNs dividend-weighted ETFs. And given the events of the last several weeks, another interesting opportunity has popped up in an unexpected corner of the market: municipal bonds [see also Bond ETFs: 12 Stops Along The Risk/Return Spectrum].
Municipal bonds are generally thought of as low risk securities, but the last several weeks have seen a bloodbath in the munis market. Muni bonds are special in that they are tax exempt, which can translate into a competitive tax-equivalent yield for investors who fall into one of the top tax brackets. This advantage allows municipalities to compete with taxable issuers for investor dollars, and will generally provide an advantage in terms of financing. For example, a municipal bond paying a rate of 4% may be more attractive than a corporate bond paying out a yield of 6%, as an investors in the 35% tax bracket would see the after-tax yield on the corporate debt fall from 6% to 3.9% [see also Look Out Below! Muni Bond ETFs In Freefall].
The past few months have been a turbulent period for muni bond markets, as prices have been plummeting due to a number of factors that have combined to create strong headwinds in the industry. For starters, many are worried about muni issuers defaulting on their outstanding debts, and increasingly concerned that the federal government either won’t be willing or able to provide a bail out. Much of the attention has shifted to California, where the budget deficit is expected to top $25 billion for the next fiscal year and the state has issued a wave of new debt to meet this shortfall in the near-term. But unfortunately, this new issuance will be met with low buyer demand. “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.
More recently, the news surrounding the Build America Bond program has been the main culprit of the muni slaughter. The Build America Bond program began in April of 2009 as a part of the initial U.S. economic stimulus. The program’s intention was to reduce the cost of borrowing for both state and local governments. “More than $165 billion of these bonds have been sold, accounting for about 22% of all new municipal debt, according to data from the U.S. Treasury Department,” writes Romy Varghese. The program offers a 35% interest rate subsidy from the federal government on taxable bonds brought to market by various municipalities. With this initiative likely coming to an end, numerous state and local municipalities have issued a wave of new bonds to take advantage of the BAB program before it runs out. Moreover, investors are now anticipating a surge in issues of traditional municipal debt next year as the BAB program expires, flooding the market and forcing issuers to raise interest rates [see also Uncertain Future For Build America Bond ETFs].
As prices have tumbled in recent weeks, yields on muni bond ETFs have jumped. While this corner of the bond market obviously remains very risky, there are some interesting opportunities that could deliver solid current returns if we manage to avoid a wave of muni defaults:
Build America Bond Portfolio (BAB)
This fixed income fund is designed to track the performance of U.S. dollar-denominated Build America Bonds publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. market. Top holdings include debts issued by Wisconsin, New York, and California. As a taxable fund, BAB’s 30 day SEC yield currently sits at 5.9% (assuming a 35% tax rate, investors will take home 3.8%). Many are worried about what will happen to this ETF assuming the Build American program is coming to an end. A quick glance at the maturities of the fund assures investors that over 80% will not mature for at least 15 years, so this ETF isn’t going anywhere anytime soon. These bonds will continue to be traded on the secondary market as the years go on, until the fund eventually dissolves once all of its holdings hit maturity (with 35% of maturities 25 years and over, BAB should be around for years to come) [see also Wide World Of Muni Bond ETFs].
Market Vectors High Yield Municipal Index ETF (HYD)
Van Eck‘s HYD tracks an index which has a 25% weighting in investment-grade triple-B bonds and 75% weighting in non-investment grade bonds. This ETF’s holdings allocate to debts issued by municipalities in New Jersey, Texas, and Puerto Rico among others. HYD’s 30 SEC yield recently stood at 6.7%, which is equivalent to an impressive 10.4% in the 35% tax bracket. Even for investors in the 25% tax bracket, the tax equivalent yield is still more than 9%, a juicy addition for yield-thirsty investors. For investors in the top tax brackets, HYD could offer a yield that beats high yield corporate bond ETFs such as JNK or HYG by more than 300 basis points, a considerable margin considering the nature of the issuers [see also Junk Bond ETFs: Too Good To Be True?].
iShares S&P National Municipal Bond Fund (MUB)
MUB, which seeks to replicate the performance of the S&P National AMT-Free Municipal Bond Index, is the most popular way to access the muni market through the ETF structure. The vast majority of MUB’s holdings will mature beyond the 10 year mark giving investors another option in the long-term bond market. The 30 day SEC yield for this ETF is currently 3.4%, which has a tax equivalency of 5.2% for those in the 35% bracket. At that level, MUB offers a considerably more attractive yield than LQD, and isn’t that far off of junk bond ETFs [see fundamentals of MUB here].
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Disclosure: No positions at time of writing.