Muni Bond ETFs: New York vs. California

by on March 26, 2010 | ETFs Mentioned:

With interest rates near record lows and expected to remain there for the foreseeable future, many investors have begun searching for alternatives to Treasuries that offer more attractive yields (see Five Bond ETFs For Yield-Hungry Investors). Junk bonds and closed-end funds have been popular choices, but some investors in higher tax brackets have embraced municipal bonds for their potential tax efficiencies; the interest payments on these bonds are exempt from federal taxes (and in many cases state taxes as well).

More and more investors are utilizing ETFs to achieve exposure to municipal bonds. There are now more than 20 municipal bond ETFs with more than $6 billion in aggregate assets, a remarkable increase from just one year ago. The majority of these assets are in ETFs that maintain exposure to a basket of securities issued by governments across the country. But there are also a handful of funds that focus specifically on municipal bonds issued by a particular state. In the mutual fund world, there are a number state-specific muni bond funds available, including those targeting Kentucky, Illinois, and Minnesota. Municipal bond ETFs haven’t reached the level of granularity available through mutual funds, but there are several products focusing on New York and California. While limiting exposure to a single state obviously carries some risks, the return potential offered by some of these funds has made them appealing to certain investors.

California Budget Woes

California Munis Offer Good Value Right nowCalifornia has been in dire financial straits for several years now, as shrinking tax revenues and soaring expenses have created a recurring pattern of budget standoffs. Governor Arnold Schwarzenegger faces the challenge of closing a $20 billion deficit over the next year, and appears to be relying mostly on spending cuts to do so. California has the largest economy of any U.S. state, but has been hit hard by the double whammy of a real estate bubble and climbing unemployment. The jobless rate climbed above 12% recently, indicating that it will be a while before tax revenues begin climbing again.

The budget crisis has now forced California to begin opening the doors at many of its prisons and eliminate supervision from parole officers for non-violent offenders. The state is also considering the legalization of marijuana to generate additional revenues. It has also caused created anxiety among investors worried about the ability of California municipalities to repay their debts. The iShares S&P California AMT-Free Municipal Bond Fund (CMF) now has an S&P rating of “A.” While still investment grade, this rating is a notch below most national muni bond funds. About 25% of CMF’s holdings have a Moody’s rating below “Baa1.”

Fund Credit Rating (S&P) A AA- AA-
30 Day SEC Yield 3.53% 2.92% 3.14%
Tax Equivalent SEC Yield* 6.01% 4.93% 4.83%
Distribution Yield 4.33% 3.89% 4.07%
Effective Duration 7.88 7.08 7.43
*Assumes 41% tax rate for CMF and 39.5% for NYF

To compensate for this risk, CMF offers a pretty attractive return, especially to those is high tax brackets. The current distribution yield is about 4.3%, about 25 basis points higher than the iShares S&P National AMT-Free Municipal Bond Fund (MUB). On a tax equivalent basis, this yield looks even better; those paying 35% federal taxes and 9.3% in California state taxes (for a blended rate of about 41%) would be getting a tax-equivalent distribution yield of about 7.4%.

New York: Not Much Better?

New York’s financial mess receives far less publicity than its west coast counterpart, but the situation in the Empire State is far from ideal. Richard Ravitch, the lieutenant governor of New York, recently proposed a plan that would involve selling bonds to cover operating expenses.

Proponents of the plan note that a similar approach was successful in the 1970s when New York City was facing bankruptcy. But those opposed to the idea of “deficit borrowing” note that a downgrade in the state’s credit rating could be one of the many consequences of increased leverage. The Debt Reform Act of 2000 forbids the state to issue debt to cover operating expenses, but lawmakers have routinely ignored the regulation. According to the state controller’s office, New York has borrowed nearly $8 billion in recent years to cover operating expenses for the state, city, and school districts.

This potential crisis apparently hasn’t worried investors nearly as much as the situation unfolding in California. The iShares S&P New York AMT-Free Municipal Bond Fund (NYF) has a comparable S&P credit rating to MUB and a lower 30-day SEC yield and distribution yield.

Disclosure: No positions at time of writing.