After one of the most spectacular runs in their history, it seems that the wheels are falling off the municipal bond train. Fears about the Fed’s tapering and rising interest rates, as well as some high profile city defaults have caused many investors to begin dumping the normally sleepy bond sector in spades. Outflows of popular muni funds- like the Market Vectors High-Yield Muni ETF (NYSE:HYD)–have been swift and several analysts have cautioned that more could be in store.

However, as investors have fled, the opportunity to score some pretty big bargains has finally emerged. There’s still plenty of reasons why a portfolio should include allocations to muni bonds. The recent sell-off could be a great opportunity to load up on the sector once again.

Weeks Of Outflows   

The normal staid and boring muni sector has been rocked by a series of events that have investors fleeing for the exits.

First, tapering fears have muni investors shaking about rising rates. The problem is that most municipal bonds are long dated- sometimes it takes 30 to 50 years for them to mature. As interest rates rise, bond prices fall and those bonds with a longer duration feel that hit harder than shorter ones. While no one can really guess when the Fed will start to taper its quantitative easing programs, that taper will come eventually.

Secondly, in recent months there have been a wave of large scale defaults from several municipalities. While the city of Detroit’s bankruptcy made headlines, other smaller cities have flowed suit- including cities in Pennsylvania, Alabama, Rhode Island and California. At the same time, downgrades and rising debt costs in Puerto Rico have also contributed to the nervousness.

These two main factors have caused 25 weeks of outflows from muni bond funds- averaging $722 million a week. 

Yet, there are still positives facing the sector- that includes high taxes for individuals. Tax reforms enacted at the end of 2012 will push the top income-tax rate to 39.6%. Additionally, the higher dividend tax of 20% and the new 3.8% Medicare tax on unearned income makes munis the place to be for higher earners. That fact should help support higher muni bond prices considering supplies of new bonds have been small. Even without this, our plodding along economy bodes well of bonds of all types- including munis.

Meanwhile, while the defaults have caught the public’s attention, they still represent such a small percentage of the total muni market. And even in those defaults, many bond holders received favorable resolutions. For example, Rhode Island passed a bill that gave bondholders a lien on property taxes to support its muni bonds in default.

Adding A Swath Of Sewer Bonds

Given that some of the nervousness in the sector may be unjustified, investors have the opportunity to re-up their exposure to the sector.

The easiest way can be through the immensely popular iShares S&P National AMT-Free Muni Bond ETF (NYSE:MUB). The fund spreads its $3.0 billion in assets around 2218 different municipal bonds and currently yields a tax-free 3.21%. Expenses are also cheap at 0.25%. For investors looking for a more active touch, the PIMCO Intermediate Muni Bond Strategy (NYSE:MUNI) could be used. The fund is currently focusing on "quality" versus yield and could be a good bet if the rally continues.

The only drawback to these two muni-superstars is their relatively long durations and sensitivity to interest rates when the Fed tapers. That means splitting an investment in them with the SPDR Barclays Capital Short Term Muni (NYSE:SHM) could be in order. The funds short term holdings will help cushion against rising interest rates. By pairing it with either MUB or MUNI, investors get a slightly higher yield and some interest rate protection.

Finally, there is plenty of ways for investors to add some “spice” to their muni positions. The new db X-trackers Municipal Infrastructure Revenue Bond Fund (NASDAQ:RVNU) focuses its holdings on bonds that supported by revenue from projects such as toll roads or bridges, while the Market Vectors CEF Municipal Income ETF (NASDAQ:XMPT) holds a portfolio of muni bond closed-ended funds. That focus on CEFs gives XMPT a hefty 6% tax-free yield. 

The Bottom Line

As interest rate/taper and default fears have taken hold, investors have fled muni bonds in spades. That outflow could be just what value hunters are looking for. There are plenty of positive reasons on why munis should still be in your portfolio. The previous picks might ideal ways to play the opportunity.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

Related Articles
  1. Mutual Funds & ETFs

    Why You Should Invest In Municipal Bond ETFs

    These versatile instruments have become popular with investors in higher tax brackets and fill a specific niche in the wide selection of fixed-income offerings.
  2. Taxes

    Avoid Tricky Tax Issues On Municipal Bonds

    Learn the rules every investor should know before buying into this "tax-free" investment.
  3. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
  4. Investing News

    Bill Gross: It's a Xanax Existence for the 99%

    Read about the investment letter from famed bond king Bill Gross for 2016. See how he says the 99% are living a Xanax existence while the 1% prosper.
  5. Mutual Funds & ETFs

    Pimco’s Top Funds for Retirement Income

    Once you're living off the money you've saved for retirement, is it invested in the right assets? Here are some from PIMCO that may be good options.
  6. Chart Advisor

    Watch This ETF For Signs Of A Reversal (BCX)

    Trying to determine if the commodity markets are ready for a bounce? Take a look at the analysis of this ETF to find out if now is the time to buy.
  7. Retirement

    Retirees: How to Survive When Interest Rates Drop

    Low interest rates are a portfolio killer if you're living off of investment income. Some strategies for dealing.
  8. Mutual Funds & ETFs

    5 Vanguard Fixed Income Fund Underperformers

    Learn about three Vanguard fixed income mutual funds that underperform compared to their benchmark indexes. Find out why low expense ratios are important.
  9. Mutual Funds & ETFs

    ETFs Can Be Safe Investments, If Used Correctly

    Learn about how ETFs can be a safe investment option if you know which funds to choose, including the basics of both indexed and leveraged ETFs.
  10. Mutual Funds & ETFs

    Top 3 Allianz Funds for Retirement Diversification in 2016

    Discover the top three Allianz funds for retirement diversification in 2016, with a summary of the portfolio's managers, performance and risk measures.
RELATED FAQS
  1. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
  2. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  3. What are the maximum Social Security disability benefits?

    The average Social Security disability benefit amount for a recipient of Social Security Disability Insurance (SSDI) in 2 ... Read Full Answer >>
  4. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  5. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  6. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center