Despite all the dire predictions, the municipal bond market continues to impress. As the low interest environment continues to persist, investors have been drawn to anything with some semblance of a yield. To that end, capital inflows into the sector remain robust and like most other fixed-income asset classes, yields have been pushed down to historic lows. While most of capital gain component of the formerly "sleepy" security type is probably finished, the Fed's continued plan to keep rates low until 2014 bodes well for the bond's tax-free yields. For investors, munis have appeal going forward and still represent a safer fixed income option for portfolios.
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The Keys to the City Still Shine
As 2010 ended and the credit crisis really dug in its heels, a variety of pundits began raising the alarm about the pending municipal bond implosion. Perhaps the most detrimental to the sector was credit analyst Meredith Whitney, who became famous by predicting Citigroup's (NYSE:C) dividend cut. Whitney predicted "hundreds of billions of dollars" of municipal defaults on the T.V. show 60 Minutes. Defaults were on the rise, unemployment was high and those with jobs were in no mood to approve tax increases. The general consensus was that both states and local municipalities had overextended themselves too far and in the current poor economic environment were doomed.
Although muni bond issuers' default rates throughout 2010 and 2011 were higher than historical averages, many of these defaults arose from one-time projects funded by special revenue bonds. The bulk of the bond sector remained unscathed and the predictions of doom & gloom never happened. In fact, quite the opposite occurred. In 2011, the muni market gained 10.7%, outpacing both, the S&P 500 Index which returned 2.1% and general bond market which gained 7.9%.
While most analysts estimate that the sector won't see those kinds of gains for the rest of 2012, there is plenty of evidence supporting continued gains for the municipal bond sector. As interest rates hover near zero, demand for munis continues to outstrip supply. In the week ending June 20, investors added nearly $555 million into muni bond mutual funds representing the tenth straight week of inflows. This follows a $365 million addition in the prior week. With the Bush-era tax cuts expiring at the end of the year, more investors will find themselves in higher tax brackets. This makes muni's current valuations a bargain as their tax free coupon payments could be worth more in the years ahead.
SEE: Fatal Seduction Of The Municipal Bond Insurers
Buying Some Sewer Bonds
For investors currently in higher tax brackets or for those who expect to be when the Bush-tax cuts expire, the muni sector still represents a great value. While it is possible for investors to add individual municipal bonds to a portfolio, exchange-traded funds (ETFs) make diversification across the sector easy. No one fund does that better than the iShares S&P National AMT-Free Muni Bond (ARCA:MUB). The fund spreads its more than $3 billion in assets around 2037 different municipal bonds and currently yields a tax-free 2.86%. For investors looking for a more active touch, the PIMCO Intermediate Muni Bond Strategy (ARCA:MUNI) could be used. The fund is currently focusing on "quality" versus yield and could be a good bet if the rally continues.
For investors looking for more yield, analysts recommend skipping longer duration bond funds like the Market Vectors Long Municipal Index ETF (NYSE:MLN), and focusing on shorter but lower quality issuers. Both the Market Vectors High-Yield Muni ETF (ARCA:HYD) and SPDR Nuveen S&P High Yield Muni (ARCA:HYMB), offer exposure to the lower end of the credit spectrum. Both funds yield 5.4%.
Finally, some of best and strongest yields can be had in closed-end funds. The closed-end funds use of leverage causes many to yield around 6.5%; that's a 10% tax-free yield for someone in the 35% tax bracket. The Nuveen Municipal Value Fund (NYSE:NUV) has been paying dividends for 25 years and currently yields a taxable equivalent yield of approximately 7.05%.
SEE: An Introduction To Closed-End Mutual Funds
The Bottom Line
Despite the dire predictions, the municipal bond sector is seeing great returns. However, bonds in the sector continue to offer value for those investors in higher tax brackets. The previous funds, along with the PowerShares Insured National Muni Bond (ARCA:PZA) make ideal selections to play the sectors still relatively high tax-free yields.
At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.