Are Municipal Bond ETFs A Good Value?

• By Simon Maierhofer, Co-Founder
• On 12:06 pm EST, Thursday February 19, 2009

Gift certificates are great, aren't they? They take the guess work out of giving. No more unwanted returns, no more re-gifting. Even better, gift certificates often sell at a discount - buy $100 for only $80. But how would you feel if you gave (or received) a gift certificate for Sharper Image (now out of business)?

Municipal bonds these days remind me of discount gift certificates. They look like a good value, but do you have to be afraid that the bond issuer might go belly up, too?

When it comes to investing, diversification is always a good thing. A basket of stocks offers more safety than an individual stock, a basket of municipal bonds offers more safety than an individual muni bond.

Right now, municipal bonds appear to offer compelling yields. How compelling? Morningstar reports that the yield on a typical AAA rated muni bond is near 4.72%. Even the highest yielding Treasury bonds yield no more than 3.31%. Due to their preferred tax treatment, muni bonds historically yield 5% - 20% less than comparable Treasury bonds. Currently muni bonds pay 43% more than comparable Treasuries.

The PowerShares Insured National Municipal Bond Portfolio (NYSEArca: PZA - News) boasts a yield of 5.11%. PZA's underlying bond issues mature between 2030 and 2040. The iShares Barclays 20+ Treasury Bond Fund (NYSEArca: TLT - News) which holds Treasuries of comparable maturity, yields only 3.50%.

Constituents of PZA (an insured bond fund) must have an unconditional contractual guaranty by an insurance company for any unpaid interest and principal. Constituents of TLT are backed by the full faith and credit of the U.S. government. The current yields tell us that investors trust government backed bonds more than municipal bonds.

Contrary to current performance and investor's sentiment, Morningstar has highlighted the 'attractiveness' of muni's since 2007. In a recent article, Morningstar stated: 'We were correct at the time, munis did look cheap, but what we didn't anticipate fully was that they would come to look much cheaper throughout the course of 2008.' With a touch of poetry, Morningstar is saying that they were right even though muni's have dropped since their recommendation.

Don't fight the tape

Municipal bonds are backed by the taxing power of the issuing municipality. After years of economic prosperity, municipalities are experiencing falling tax receipts. New York for example, which depends on Wall Street for about one fifth of its revenue, is facing a $2 billion budget shortfall. California is facing an $11.2 billion shortfall. Collectively, U.S. states seek at least $126 billion of federal funding to plug their respective budget holes.

Six of 15 municipal bond ETFs track California and New York. The biggest ones are iShares S&P California Municipal Bond ETF (NYSEArca: CMF - News) and iShares S&P New York Municipal Bond ETF (NYSEArca: NYF - News). The SPDR Barclays Capital CA Muni Bond Fund (NYSEArca: CXA - News) comes with a juicy 4.35% yield.

High yields paid in the municipal sector are reminiscent of the double digit yields currently seen in the financial and real estate sector. The Financial Select Sector SPDRs (NYSEArca: XLF - News) pay 6.16% while the iShares DJ US Real Estate ETF (NYSEArca: IYR - News) pays 8.24%. Our previous analysis showed that double digit yields in real estate ETFs come with a shot of risk. When fishing for high yields you have to ask yourself if the 'cash incentive' is worth the associated risk.

How safe is municipal debt? A study of average cumulative 10-year default rates for investment-grade munis from 1970 to 2005, conducted by Moody's Investors Service, placed the level at 0.07%, versus 2.23% for comparable corporate bonds. Before you go out to buy your muni fund, consider this; The above mentioned 35-year time frame was marked by a raging bull market compared to today's furious bear. Furthermore, AIG (NYSE: AIG - News) was rated A++ or AAA by most credit rating agencies not too long ago.

The same study also highlights that the average cumulative 10-year default rate for below investment-grade muni debt was many times higher than investment-grade debt. 4.29% was the default rate for this category.

A look at the chart reveals that municipal and corporate bonds have moved in tandem over the past year with corporate bonds absorbing most of the volatility. The iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEArca: LQD - News) dropped 20% when investors got spooked in September of last year while the iShares S&P National Municipal Bond Fund (NYSEArca: MUB - News) dropped 12%.

If it sounds too good to be true...

As prices drop, yields tend to flourish. This scenario is often seen in recessionary and depressionary environments. For the first time since 1992, broad market ETFs like the Dow Jones (NYSEArca: DIA - News) and S&P 500 (AMEX: SPY - News) yield more than 3%. The yield doubles as equities prices dropped by nearly 50%. Remember, above average cash incentives (yield or dividends) may be a red flag indicative of struggling asset classes.

Buzz up!