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California Debt Upgrade Puts These Muni Bond ETFs in Focus

Zacks Equity Research

After some pretty rough trading in 2013, the municipal bond market has found it easy going this year. Concerns about fluctuating interest rates and financial soundness that troubled the munis last year appear to have taken a back seat for the time being. And the reasons are demand-supply imbalance, falling interest rates and improving credit quality of issuers, resulting in an uptrend in the munis space.
Most recently, a key U.S. state – California – has been upgraded to the highest level in 13 years by credit agency Moody’s on account of an improving financial position and relatively higher employment growth, per a Bloomberg report. Moody’s has raised California’s rating to Aa3 from A1- – the highest since 2001 and ahead of Illinois and New Jersey.
California is believed to have taken some great measures to bring its state from a deficit of $25 billion to a record surplus in a span of three years. Though still at an alarming level, the state’s debt metrics are seeing an improving trend. The recent upgrade might be beneficial for the state in terms of borrowing costs. A higher rating usually reduces the cost of borrowing. 
The state’s government has recently agreed to form a general fund budget to reduce debt, invest in public schools and protect against economic downturns (read: Three Municipal Bond ETFs for 2014).
Some of the recent improvements in the state of California might lead other rating agencies to follow Moody’s footsteps. Standard & Poor’s and Fitch Ratings currently have an “A” rating for this U.S. state, after an upgrade in 2013.
Thus with improving credit ratings on the back of rising fiscal health and falling credit risks, municipal bonds might continue to attract investors. Moreover, the Fed’s promise to keep interest rates low for a considerable period acts as an added boon.
Furthermore, California bonds can be quite attractive especially for taxpayers in the higher brackets as it is exempt from both state and federal income taxes (read: 5 Long Term ETF Buys for Your Roth IRA Contribution).
Thus for investors seeking to bet on California bonds following the recent upgrade and given their tax benefits, we have highlighted below three California Muni ETFs that offer broad exposure to this space:
iShares California AMT-Free Muni Bond ETF (CMF)
The fund tracks the performance of the S&P California AMT-Free Municipal Bond Index in order to provide exposure to investment grade municipal bonds issued in the state of California.
CMF targets the intermediate end of the curve with a weighted average maturity of 5.73 years. However, an effective average duration of 6.48 years signifies a modest level of interest rate risk.
The fund holds a basket of 451 bonds and charges 46 basis points a year as fees. In terms of sectors, bonds from the various purpose sector (23.37%) occupy the top spot, followed by utility (22.73%) and education (13%) bonds.
This California ETF has returned 7.5% so far this year, beating the most popular municipal bond fund – iShares National AMT-Free Muni Bond ETF (MUB) – which has returned 5.7% this year.
SPDR Barclays California Municipal Bond ETF (CXA)
The fund tracks the Barclays Managed Money Municipal California Index holding a basket of 93 bonds (see all Municipal Bond ETFs here).
CXA focuses on the long end of the curve with a weighted average maturity of 13.19 years and duration of 8.54 years. Sector-wise, Go Local, Water & Sewer and Power bonds take the top three spots.
The fund has returned 7.4% this year and has a dividend yield of 2.62%.
Insured CA Municipal Bond Portfolio (PWZ)       
PWZ primarily invests in insured municipal securities that are exempt from federal income tax and California state income tax.
The fund holds a basket of 53 bonds and also focuses on the long end of the curve with average maturity of 22.08 years. PWZ has an attractive dividend yield of 3.88% and has a 30-Day SEC yield of 2.79%.
The fund has added 10.2% this year, the most in the California Munis space (also read: Top Ranked Muni Bond ETF in Focus: BABS).   
Bottom Line
Though California has recently been upgraded by Moody’s, we still believe that investors should cautiously approach the California Muni bond ETF space. The state still has high levels of debt, a volatile tax revenue structure and governance restrictions.
Moreover, credit rating companies have often criticized this state for its failure to set aside some money in reserve during periods when the economy is doing well. Apart from CMF, which currently carries a Zacks ETF Rank #3 or Hold rating, we have a Zacks ETF Rank #4 or Sell rating on the remaining two California Munis ETFs suggesting that caution still needs to be taken for this segment in the near term.
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Read the analyst report on CMF

Read the analyst report on MUB

Read the analyst report on CXA

Read the analyst report on PWZ

Zacks Investment Research

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