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Muni bonds had a lousy end to a great year. Shown below is a price chart for SPDR Barclays Municipal Bond ETF (TFI), which underwent a significant sell-off along with nearly any municipal bond fund due to uncertainty regarding the tax-exempt status of municipal bonds as an asset class (Figure 1).

Figure 1: An Ugly End to a Great Year (click to enlarge).

Is this sell-off a buying opportunity? It likely is for a number of reasons. First, the tax-exempt status of municipal bonds is very unlikely to change in the near term. It will be impressive if Congress can get its act together enough to simply avert the fiscal cliff; rewriting the tax code within the next few days seems to be highly unlikely. Furthermore, while the yield on municipal bonds is relatively low, the spread to Treasury bond yields is significantly higher than its historical average (Figure 2).

Figure 2: Municipal Bond Yields Vs. 10 Year Yields (click to enlarge).

The current spread of 178 basis points is well above the average of approximate parity that municipal bonds have enjoyed relative to treasuries. While yields have headed closer to parity this year, there is still a long way to go. Municipal bonds have the advantage of higher yields and an even wider advantage once one considers their tax exempt status. It is this tax exempt status which has historically allowed them to trade near parity to Treasuries even though they have greater risk.

Furthermore, if the municipal bond index shown above and the 10-Year Treasury note yield are entered into a spreadsheet and the price for each is derived via the following formula (treating the muni index as a 10 year duration bond):

Price = 1/(1+Rate)^10

- there is a correlation of 0.36 between the spread of a 10-year treasury note and the price appreciation realized within one-year from the municipal bond index. In other words, buying when the spread is high tends to gather greater capital appreciation.

The current sell off in municipal bonds thus appears to be a buying opportunity, particularly for bonds held in taxable accounts. A number of ETFs offer exposure to municipal bonds. PIMCO has several closed-end funds: they are levered offering higher risk, but higher returns: PIMCO Municipal Income Fund (PMF), PIMCO Municipal Income Fund II, (PML), PIMCO Municipal Income Fund III (PMX). The yields run from just under 6% to 6.8%, while the premium to NAV is currently 4.7% to just over 10%. The second fund is probably the safest with the lowest premium, but also the lowest yield.

More traditional ETFs include: iShares National Municipal Bond ETF (MUB), SPDR Short-Term Muni ETF (SHM), Powershares Insured Muni ETF (PZA), SDPR Nuveen Barclays Muni Bond ETF, PIMCO Intermediate Municipal Bond ETF (MUNI).

Source: Is Now The Time To Buy Municipal Bonds?