Sector Watch: Municipal Bonds

Municipal bonds are issued by states and municipalities and typically have tax advantages relative to other fixed income assets.  In general, income from muni bonds is tax exempt at the federal level and at the state level for investors living in the issuing state.  Municipal bonds have historically been favored by investors in high tax brackets who, of course, derive more benefit from the tax exemptions by virtue of being in the highest tax brackets.

The conventional wisdom is that municipal bonds should only be held in taxable accounts because munis held in tax deferred accounts such as IRAs and 401(k)’s do not enjoy a boost in effective yield due to a reduction in taxes paid.  The conventional notion, however, that munis will have a pre-tax yield below other bonds with similar credit risk and duration is not always true.  In recent years, for example, the yields on some municipal bonds have been sufficiently high relative to treasury bond yields that munis have been attractive even without a tax advantage.  There are allocations to municipal bonds in the Target Date Folios, for example, and these allocations were determined to be attractive even without any tax benefits.

Municipal bonds have recently gotten renewed attention in anticipation of higher tax rates, especially for high income investors.  In addition, bond guru Bill Gross has recently boosted interest in munis, suggesting that this class of bonds is uniquely attractive in the current environment.

Performance

Municipal bonds have had a very good year in 2012 and their trailing 3-year track records are impressive as well.  As a result, the yield on munis has been pushed down to a low not seen since 1967.  As with all bonds, an increase in prices results in a decline in yields.  The PowerShares Insured National Muni Fund (PZA) has a trailing 1-year return of 12.9%, 3-year return of 8.3% per year.  The returns from the iShares S&P National AMT-Free Muni Fund (MUB) are similar, albeit slightly lower.

The Folio Investing Municipal Bond Folio contains four equally weighted muni bond ETFs.  The trailing 12-month return for this Folio is 8.73% and the 3-year annualized return is 6.0%.  The Folio holds a 25% allocation to both PZA and MUB, along with 25% allocations to the SPDR Nuveen Barclays Muni Fund (TFI) and the SPDR Nuveen Barclays Short-Term Muni Fund (SHM).  The 25% allocation to the short-term fund reduces the return of the Folio but also reduces risk.

The trailing 12-month yields of the four funds held in the Folio, the iShares Core Total Bond ETF (AGG), and the iShares 7-10 Year Treasury Fund (IEF) are shown below, along with the trailing 5-year volatility, a standard measure of risk:

Yield as of November 13, 3012 and 5-year volatility through October 2012

Source: Author

In the equal weighted Folio of these funds, the trailing 12-month return is 2.8%.  Obviously you can get more yield by reducing the allocation to the lower-yield short-term muni fund and increasing the allocation to the higher-yield funds or by simply buying one of the higher yield funds rather than purchasing the Folio.

The iShares Core Total Bond ETF (AGG) has a trailing 12-month yield of 2.39%.  The muni Folio has a higher yield than AGG, even before we take any potential tax advantages into account.  The muni Folio is, however, riskier than AGG as evidenced by the higher volatility.  The yield of the equal-weight Folio is considerably higher than that for the intermediate-term Treasury index fund (IEF) and has lower risk than the Treasury fund.

Industry Overview

States, cities, counties and other governmental entities can issue municipal bonds to provide the capital to construct roads, schools, sewers, and other costly infrastructure.  These bonds can be structured as either general obligation bonds or revenue bonds.  General obligation bonds are backed by the full faith and credit of the issuing entity.  Revenue bonds are backed by the revenue earned by a specific project for which the bond is issued.  A revenue bond might be issued to build a toll road, for example, and the principal and interest payments to bond holders are funded by the revenues generated by the toll road.

Like all bonds, municipal bonds have interest rate risk.  If interest rates rise, investors will sell lower-yielding bonds issued in a lower rate environment.  Conversely, if interest rates fall, previously issued high-yield bonds will be more attractive.  Municipal bonds also have default risk, consistent with other bond classes with the exception of Treasury bonds, which are commonly treated as though they have zero default risk.  Municipalities can and do default on their debts.  This is the risk that investors are getting paid to take via higher yields than they could achieve using safer investments.  Well-known analyst Meredith Whitney predicted in late 2010 than municipal bonds would see a surge in defaults and that prediction led to a sell-off in munis.  Over the two years since she made that call, however, we have not seen an enormous increase in default levels and the muni market as a whole has rallied.  There has, however, been some increase in default rates and that is a cause for concern, particularly with the low yields available in current market conditions.  The yield available to investors is low by historical standards and default rates are increasing.

A threat facing municipal bondholders going forward is the widespread under-funding of public pensions.  Many public pensions do not have sufficient assets to provide the retirement incomes that they have promised.  Pension obligations compete with the interests of bondholders.

Portfolio Holdings

The Municipal Bond Folio consists of ETFs that invest in municipal bonds and is designed to provide income exempt from U.S. federal income taxes.

Symbol
Company
Weight
Ishares Trust S&P Natl Mun B
25.00%
Powershares Global Etf Trust Insur Natl
25.00%
Spdr Series Trust Shrt Term Muni
25.00%
Spdr Series Trust Leh Mun Bd Etf
25.00%

Source:Folio Investing
[Note: The holdings are re-evaluated and updated (as needed) on a quarterly basis.] 

Commentary 

Munis are attractive in late 2012 due to (1) their tax advantaged income and (2) their relatively high yields as compared to Treasuries.  Munis have default risk, of course, and the future level of defaults is largely unknown.  The worst case for munis would be an environment of rising interest rates and a stalled economic recovery.  Higher interest rates make previously-issued bonds undesirable and a lack of economic growth results in stagnant or falling tax revenues, making it harder for issuers to keep up with their debt repayments.  The historical risk and default levels associated with municipal bonds over the past five years, including the financial crisis starting in 2008, have not been exceptionally high.  Munis have also benefited greatly from falling interest rates as a result of the Fed’s Quantitative Easing.

Related Links:

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

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