Municipal Bond ETF Considerations

By Gregory S. Davis | June 24, 2009 AAA

Municipal bonds can make a positive contribution to an investor's portfolio, by offering tax-free returns in some cases, and a steady stream of income over time.
Cities, counties and states issue municipal bonds in order to fund the development of projects including hospitals, airports and school systems. Let's take a glance at a couple of issues investors should consider before determining if a municipal bond ETF makes sense for their investment portfolios.

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Strengths
The underlying assets of a municipal bond ETFs like the iShares S&P National Municipal Bond ETF (NYSE:MUB) displays the diversity of holdings across state as well as across project development initiatives available to investors. The MUB fund's top holdings include general obligation bonds from states including North Carolina, Illinois and Oregon, along with school construction bonds from Massachusetts. General obligation bonds are considered the safest among the variety of municipal bond offerings, since they are secured by the taxing powers of the issuing authority. The security of municipal bonds and their ability to offer a steady stream of income have made them a popular option for investors. The MUB fund has current yield of 3.6%. Behind US Treasuries, municipals are considered by many to be the next safest category of investment. (For more, see The Basics Of Municipal Bonds.)

Risks
Tough economic times and lower tax revenues could lead to states having difficulty repaying those invested in municipal bonds. The risk is less pronounced for general obligation bonds, but they are amplified for municipal bonds tied to private institutions like hospitals, due to the risk of bankruptcy. The threat of future inflation, resulting in higher interest rates, could also mean lower returns for municipal bonds with longer times frames until maturity. In this case, municipal bond ETFs with a shorter average maturity, in the neighborhood of three years, like the SPDRS Barclays Capital Short Term Municipal Bond ETF (NYSE:SHM) and the S&P Short Term National Municipal Bond ETF (NYSE:SUB), would stand to perform better than funds with longer maturities, like the SPDR Barclays Capital Municipal Bond ETF (NYSE:TFI) with its average maturity just above 10 years.

State Options
Municipal Bond Fund ETFs are also available for individual states like California and New York. Two of the biggest funds in terms of total assets investors can investigate are the iShares S&P California Municipal Bond ETF (NYSE:CMF) and the iShares S&P New York Municipal Bond ETF (NYSE:NYF). Asset size is another consideration, since the smaller a fund is, the greater the possibility of the fund being closed down.

Final Thoughts
There has been some speculation concerning whether or not higher rates for individuals will translate into an upswing in municipal bond prices in the future. The best way for investors to manage this concern and the others mentioned is to hold a variety of municipal bond funds varied by both time to maturity and underlying investment composition. (For further reading, see Municipal Bond Tips For The Series 7 Exam and Bond Basics Tutorial.)

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