The Stealth Wealth In Municipal Bonds

By Mark Whistler | March 20, 2008 AAA

The subprime mess is like the Energizer Bunny; it just keeps going and going and going... And over the past few months, municipal bond markets have begun to see their fair share of subprime fallout too.

After spiking to 5.4% in late February, interest rates on municipal (muni) bonds now average just under 5%, according to a March 14 story in The Kipling Letter. One year ago, the average yield was around 4.1%. As investors shunned risk, jurisdictions such as the Port Authority of New York and New Jersey saw rates on some of their debt jump to 20% from 4%. The larger picture is pretty complicated, but for a few bond funds the present risk within muni markets might actually be a blessing in disguise. (To learn how muni bonds work, check out The Basics of Municipal Bonds.)

Credit Ratings the Real Culprit
There's one aspect of the subprime debacle that hasn't seen much airtime, yet it's one of the true causes behind the mess. Recently, bond markets - especially municipals - have suffered, as investors fear the insurers behind the bonds may be in trouble. So, with the credit crunch smacking bond insurers in the face, they've elected to do the same for municipalities, triggering unusually high yields, which then infer elevated risk.

All of the aforementioned is partly due to many bond insurer's own sub-par credit status from ratings services like Standard & Poor's and Moody's Corporation (NYSE:MCO). Fact is, the companies who simply "judge credit" are really the culprits behind the loss of traction in muni markets.

But municipal bonds are safe, have always been safe, and will likely always be safe. It's rare for a muni to default. Occasionally it happens, like when Orange County, California went belly up, but it's rare. And, when you consider that Bear Stearns (NYSE:BSC) just lost $20 billion in market cap, in two months, municipal bonds - even those without insurance - don't look so bad right now.

Really, the market should chuck insurance on municipal bonds all together, and shift the weight solely on the Federal Reserve and U.S. Treasury - similar to five-year pre-refunded municipals, which are backed by Treasuries in escrow. However, if the Fed actually insures bonds, like the corporate insurance counterparts do, the whole situation would ease. By doing so, the credit rating companies, who are just dead weight on munis anyway, would probably just go make some other industry miserable. From the muni's perspective, credit ratings firms are bullies, and are making the whole economic situation in America more troublesome. (To learn more, read Fatal Seduction Of The Municipal Bond Insurers and Who Is To Blame For The Subprime Crisis?)

However, it is here that munis could actually be good for investors going forward, especially in savvy mutual funds and ETFs who know how to take advantage of the situation.

Munis in the Short-Term
Because of the whole economic, subprime, insurance and credit mess, many municipal bonds are coming to market with spreads above Treasuries right now. It's really a "risk premium" because of oversupply. And in the short-term the entire situation is enticing hedge funds to pick up munis too, something that could be good for individuals.

Typically, when interest rates begin to rise, municipal bonds aren't the best bet. However, given that the Fed only cut three-quarters of a point in the March 18, 2008 meeting, while the market was actually looking for a full one-point slash, the real skinny here is there's still room for more downside in rates. In June, the Fed could easily chop Fed Funds rate by another half point, bringing the benchmark to 1.75%. Should another rate cut appear, this may drive more acceleration in muni markets, even with the subprime debacle. Conversely, if and when rates begin to rise, investors may want to pull muni investments.

Trio of Muni ETFs Set to Rebound
By investing in muni ETFs, investors are able to gain the benefits of the bonds, while keeping the liquidity luxury of stocks. ETFs act as mutual funds, except investors generally see lower fees, while also being able to buy and sell intraday, versus the end of day prices mutual funds offer. This means if interest rates to begin to rise, investors can dump the muni ETFs right away. (To learn how to take full advantage of these vehicles, read How To Use ETFs In Your Portfolio.)

Here are three muni ETFs to consider:

1. Nuveen Muni High Income Opportunity (NYSE:NMZ)
2. Pioneer Muni High Income Advantage (NYSE:MAV)
3. Eaton Vance Insured Municipal Bond Fund (AMEX:EIM)

All three funds listed above have taken a beating in 2008; they're all trading negative on the year, and it is crucial for readers to note this. However, these funds could be starting to bottom out, and with muni markets on the eve of credit and insurance innovation, a reversal could be just around the corner.

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