Will Duration Destroy Muni ETF Returns?

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 |  Includes: BSV, MUB, PZA, SHM
by: Dividends & Income Daily

Tax-free income sounds great. Especially when it comes with 3% and 4% yields.

If you're in a very high tax bracket, what I'm about to tell you may not matter. The impact of the tax-free income on your bottom line may be greater than any risk that may exist. But if you're on the cusp, or frankly don't really need tax-free income, you better keep on reading. Because in the near future, some muni ETFs may just deliver negative absolute returns. Let's check them out.

Where's the Risk?

"Municipal bonds" -- the term evokes thoughts of secure and tax-free income. Well, before Detroit went bankrupt, anyway. But despite dire warnings of massive municipal defaults from the likes of Meredith Whitney in 2010, most municipalities and the bonds they issue have remained solvent and capable of meeting their debt obligations. Default risk is really a minor consideration, especially for muni investors who use mutual funds and ETFs as their investment vehicles of choice.

What are concerns are how the portfolio is constructed and, specifically, the duration of the portfolio. You see, duration is a number used to indicate the "sensitivity" of a fixed-income investment to changes in interest rates. It's a complicated calculation that includes statistics like present value, yield, coupon, final maturity and call features.

Tedium aside, what's important for investors to know is that the longer the duration -- which is expressed in years -- the more you have to gain or lose when interest rates rise or fall. For every 1% move in interest rates, the investment will gain or lose an approximately equivalent amount of value for each corresponding year of duration. In other words, an ETF with a duration of one year will lose 1% in value when interest rates rise by 1%. Likewise, an ETF with a duration of five years will lose 5% in value for each 1% increase in interest rates. The inverse applies if interest rates were to fall, but right now interest rates have nowhere to go but up.

Risky, Tax-Free Business

One fund that I like but nonetheless raises a few concerns is the PowerShares Insured National Muni Bond ETF (NYSEARCA:PZA). The ETF is based on the Bank of America Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index. (Whew!) A quick scan of its portfolio shows bonds from diverse municipalities in Georgia, New Jersey, Illinois and Texas, among others. Notably, the bonds are all insured and amount to a current yield on the ETF of 4.27%.

Now, the trouble starts with the duration. PZA's nearly 10-year duration means that if interest rates move up 1%, the value of the portfolio could move down 10%. And since there's almost no doubt that interest rates will continue moving higher, investors in the fund could lose more than two years' worth of income very quickly. So despite its impressive yield and the insured nature of the bonds backing it, for duration considerations alone, it should be avoided.

PZA is worth comparing to the iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA:MUB), which is among the largest and more liquid municipal bond ETFs. MUB has a lower yield than PZA, currently 2.95%. This can be partially attributable to its duration of 7.26, which is slightly better than PZA, but will still subject investors to sizable losses as interest rates rise.

In the end, if you really need the tax-free income and plan on holding the funds for a long time, it could be worthwhile to ride out the rising-interest rate storm. But this would be a long-haul operation. On the other hand, if those duration figures have you concerned, it may be best to switch to a short-duration municipal bond fund or even a taxable bond fund.

The SPDR Nuveen Barclays Short-Term Municipal Bond ETF (NYSEARCA:SHM), for example, has a duration of only 2.92 years -- and its yield is correspondingly only 1.07%. Another alternative is the Vanguard Short-Term Bond ETF (NYSEARCA:BSV). It is taxable, but has a duration of only 2.7 years with a taxable yield of 1.32%. Those yields may not be very exciting, but at times like these, capital preservation may be the best strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.