Red-Hot Municipal Funds

TheStreet.com

NEW YORK (TheStreet) -- ETFs that invest in Build America Bonds have been on a tear. During the past year, SPDR Nuveen Barclays Capital Build America Bond BABS returned 25.2%, while PIMCO Build America Bond Strategy BABZ returned 22.5%, according to Morningstar. In contrast, the Barclays Capital Aggregate Bond index gained 7.3%.

The Build America funds focus on high-quality municipals with long maturities. That has been a recipe for success at time when nervous investors have been fleeing to Treasuries and other safe assets. Despite their big rally, the funds remain appealing for income investors. PowerShares Build America Bond BAB yields 4.4%, compared to a yield of 2.58% for 30-year Treasuries.


While most municipal bonds are tax free, the Build America issues are taxable. The bonds were introduced in 2009 as part of the American Recovery and Reinvestment Act. Under the legislation, the Treasury covers 35% of the cost of a municipality's interest payments on the bonds. The aim was to support municipalities that were struggling to cope with the financial crisis. States and cities jumped to issue the bonds because they were cheaper to use than traditional tax-free issues. About $181 billion of the securities have been issued.

Among the biggest buyers of the bonds have been pensions. Conservative institutions favor the Build America issues because most come with top ratings of AA and AAA. In addition, many of the bonds come with maturities of 20 years or longer, a desirable feature for institutions that must plan for long-term obligations. Many of the bonds are particularly safe because they are general obligation bonds, which are backed by the full taxing power of issuers. Other Build America Bonds are backed by essential services such as water and sewer systems, which rarely default.

Since 2010, no new bonds have been issued. President Obama has sought to continue the program, but Republicans in Congress have blocked the legislation. Even if no more bonds are issued, the Build America ETFs should continue operating for at least the next several years. Because most of the bonds have long maturities, they will continue making interest payments. Demand for the bonds should remain strong. Many institutional investors and index funds must hold the bonds because they are included in the Barclays Capital Aggregate index, a common benchmark used by many money managers. If there are no more Build America Bonds, then the ETFs would have to alter their portfolios eventually, perhaps including broader collections of taxable municipals.


The PowerShares fund is the biggest and cheapest ETF in the category, with $1 billion in assets and an expense ratio of 0.28%. With a return of 19.7% in the past year, PowerShares lagged its competitors. The slow showing could be partly because the fund only has 75% of its assets in bonds with maturities of 20 years or longer. The rest of the holdings are in shorter securities. In contrast, the PIMCO fund has 94% of its assets in bonds with maturities of 20 years or more. With rates declining in the past year, the long bonds scored the biggest gains. The PIMCO fund has $40 million in assets and an expense ratio of 0.45%. The PIMCO fund is actively managed, while its two competitors are index funds.

The greatest hazard for the ETFs could be a rise in interest rates. If that happened, then prices of the long bonds could sink sharply. But with the economy sluggish and the Federal Reserve promising to hold down short-term interest rates until 2014, then it seems unlikely that rates will rise anytime soon. Municipal defaults could also pose a risk. But it now appears that most states and cities have weathered the financial crisis in sound shape. Revenues are rising again, and many municipalities have cut costs. The stronger balance sheets should ensure that default rates will remain low.

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