ETF Talk: Munis to the Rescue?

As the economy slows, one reasonably safe sector that you may want to consider is municipal "muni" bonds. Muni bonds are issued by cities, states and other local governments to raise money for all kinds of public sector construction initiatives, such as schools, roads and bridges.

With the ongoing recession, cities around the United States need to raise money. By early November of 2008, states and cities were selling nearly $6 billion in debt, including Houston’s $423 million and New York City’s $400 million. The need for cash is sparking a municipal bond rally that could be extremely profitable for ETF investors.

I think muni bond exchange-traded funds (ETFs) are definitely instruments worthy of consideration, especially given the renewed interest by President-elect Obama and his administration’s plan to beef up the nation’s infrastructure.

The competitive yields now offered by muni bonds make them extremely attractive to investors. Since the interest yielded on these bonds is usually exempt from federal taxes, and maybe even state and local taxes if the investor is a resident of the state or city that issues the bonds, you have an investment offering a one-two punch of solid yields and excellent tax savings.

However, there are certain facts about the muni bond market that investors should understand. The market for muni bonds is huge, with more than one million individual bonds and 50,000 issuers, making it more fragmented than the corporate and Treasury markets. Muni bonds usually fall into two categories. First, general obligation bonds use tax revenue to repay the debt. Second, revenue bonds are repaid by the revenue generated by the project that the bonds funded.

Both types of bonds potentially can offer high yields. By using ETFs to trade in these bonds, you will have much more flexibility, as well as lower fees than the conventional muni bond mutual funds, which have an average expense ratio of 1.10%. The chart below shows one of the better muni bond ETFs we track each week, the SPDR Lehman Municipal Bond (TFI).

Of course, muni bonds also carry risk. For example, muni bonds typically offer less transparency in pricing and are not very liquid, since such bonds usually are bought and held over a period of time by the purchaser.

Another risk is that the governments behind certain muni bonds pay companies to insure them in an effort to gain a higher rating for the debt from ratings agencies. The insurance companies themselves are at risk in the current market because of their exposure to the subprime crisis. Yet despite these risks, muni bonds have a good record for avoiding defaults.

In my view, we could be on the cusp of a significant muni bond rally. Although I am not currently recommending any muni bond ETFs, the Fed’s recent interest rate cuts have boosted bond prices. Now may be a good time for you to begin exploring how muni bond ETFs could fit into your portfolio.

As always, if you have any questions about ETFs that you’d like me to answer in an upcoming ETF Talk feature, please click here.