Bond ETFs: Time to Stock Up, As Munis Yield More Than Treasuries

Bond ETFs have sparked investor interest across the board. It's largely a by-product of the world we're living in these days, since people turn to bonds during volatile times.

Just look at the numbers: as of February 2008, there were 53 bond index ETFs. In February 2007, there were a measly 14.

As their ranks have grown, so have the assets in them. In the first quarter of this year, assets rose 16% to $40.4 billion, reports Jesse Emspak for Investor's Business Daily. According to iShares, the area isn't going to be slowing down anytime soon, either. Over the next three years, they say, the bond ETF industry could grow by 200%.

In addition to providing a place to go when the markets begin acting up, there are some bond ETFs that give access to areas they previously were unable to get into, such as international bond ETFs.

Don't forget: municipal bonds are currently in the rare circumstance of yielding more than treasuries.

Some of the many types of bond ETFs available are:

• SPDR Lehman International Treasury Bond (BWX)
• iShares National Municipal Bond Fund (MUB)
• PowerShares Insured National Municipal Bond Portfolio (PZA)
• Ameristock/Ryan 1 Year U.S. Treasury (GKA)
• iShares Lehman TIPS Bond Fund (TIP)
• Vanguard Intermediate-Term Bond (BIV)

Munis Are Yielding More Than Treasuries

It's an event like Halley's Comet, although with a little more frequency: municipal bond yields are higher than those of treasury bonds. For that reason, it makes more sense than ever to grab ETFs that hold them.

"It's something that doesn't happen very often," says Glenn Smith, associate of ETF sales at Van Eck. "Maybe once every 7-10 years or so."

Municipal and treasury bonds are considered among the safest investments around. Unlike with corporate bonds, municipalities and the government can draw money from plenty of other sources when they get in a bind - raising taxes, for example. This ability to generate money on a whim makes it significantly less likely that the bond issuer is going to default.

Traditionally, treasury bonds yield more than munis. But take, for example, the 10-year treasury bond vs. the 10-year muni: the treasury offers a 3.48% yield, while the muni offers a 4.04% yield.

Factor in the fact that municipal bonds are tax-free, and it's a big difference. Calculate your own equivalent tax yield here. In California, the tax equivalent on that muni bond is 6.65%.

Smith says the credit crisis can be blamed as the reason for the shift. Bonds are all about credit ratings, and often to secure better ratings, bond issuers will pay handsomely to have the bonds insured. The higher the rating, the lower the interest the issuer will have to pay out.

Another reason for the shift, says James Colby, municipal bond strategist at Van Eck, is that there was a "flight to quality" by investors when the crisis hit, pushing down treasury yields. Meanwhile, the Federal Reserve has been forcing the rates lower while muni bond yields have remained fairly steady.

In the past, other factors that have caused the yields of munis and treasury to switch places are geopolitical crises, or the rare instance in which a municipal bond defaults. "When it does happen," Smith says, "it can throw markets out of whack, because people get jittery."

Once those same bond insurers got caught up in the mortgage mess...you can pretty much guess the rest: the bond ratings when down a notch or two and yields went up.

In the next three to six months, as all good things, it will come to an end and everything will revert back to the mean. One of two things will happen, says Smith:

1. Treasury yields will have to come up
2. Muni yields will have to come down

In either scenario, if treasury rates go up, it makes the older bonds less valuable. If muni rates come down, you're in a good position.

Smith sums it up: "It's a win-win situation."

Among the municipal bonds available:

• PowerShares Insured National Muni Bond (PZA)
• Market Vectors Lehman AMT-Free Int Muni (ITM)
• iShares S&P National Municipal Bond (MUB)
• SPDR Lehman Municipal Bond (TFI)
• PowerShares VRDO Tax-Free Weekly (PVI)
• SPDR Lehman Short Term Municipal Bond (SHM)

Disclosure: Some of Tom Lydon's clients own shares of TIP.

Comments

[silverspring]

Nice article, long long term muni, short short term treasury might be a good bet.

[Longwave]

I'm worried that the unfunded state and municipal employee benefits will result in many of these governments defaulting on their bond obligations. Another factor affecting their ability to meet obligations is the inevitable decline in property tax revenues as the write-downs in housing values hits their tax roles. And I think it's safe to say that the rating agencies have their heads in the sand.I know most municipal bonds are insured, but we've learned from the sub-prime mortgage mess that the insurers themselves are in precarious situations.

[RichardSchweitzer]

One must keep in mind that in these articles, Tom Lydon is being INFORMATIVE, not advisory. If you want his (or his firm's) advice, it is available in a different format on other terms.

If one looks at the technical charts on these securities, it is obvious that they have been and are being accumulated at steady rate, which generally exceeds their pricing trends. Thus, "assets" are building within the holdings of the funds.

Tom is not saying the info indicates that these will provide good parking places every week, just that more people are parking here.

[yourgoldteeth]

Post busted CDOs I'm not sure I'd count on munis always being made good. I can't remember the exact circumstances, but the city of Birmingham almost went into default a few months ago. What was striking about it was not that they ran into trouble, it was that when the bondholders started making threatening noises, Birmingham told them, hey, back off. We're not going to cut staff just to make our bond payments.

There was actually a quote along those lines from some city official. Maybe he was just the only one running for re-election

I don't keep up with munis, but what's the plan for keeping credit ratings high now that two major insurers are gone? If their business had been viable seems like they'd still be around.

Without somebody to take over that role munis yields might not be coming down as far or as fast as people think.

In fact, if we get a few more Birminghams, and if they can't be bailed, they muni yields may be going up. If one of these cities actually defaults, maybe way up.

In the brave new world created by the bankers munis may not look quite as attractive side to side with treasuries. At least you know, so far, that you're going to get your money back with treasuries.

Did I miss something or did somebody come up with a plan on restoring bond insurance for munis? Without it risk premiums may start heading up if we start getting a few defaults.

And Birmingham may not be the last in line to try that out.

There's the matter of tax assessments. Anybody who walked away from his house isn't going to be paying taxes on it. And there are going to be plenty of people who had their assessments raised who won't be able to pay either - either because they lost, or will lose a job in the coming months, or because interest rates went up, or because it's time to make more than just interest only payments.

The cities and states are going to have a hard time just delivering essential services

We haven't seen the end of write offs from the banks, or any kind of real fallout from the end of the credit party. Just for the heck of it I'll accept the assumption that the U.S. isn't going to go into recession.

There's still going to be fallout from the steadily increasing total on all those bank write offs and the tightening that's set in.

Then there's inflation. The Fed seems to have figured out that there is inflation out there - and they're now making noises about no more cuts to stave it off. So there's no help for the hapless homeowner with his adjustable rate, or with stimulus to help him get reemployed if he loses his job. Hope he's got plenty socked away for house payments.

Just because the Fed has decided that it is not going to acknowledge the contribution of the price of oil to the inflation rate doesn't mean that it is going to change the dynamics of what oil at current levels will do to the economy.

If the price of oil doesn't come down and stay down soon the mood is going to get a little dark out in those subdivisions that take an hour to drive to work from.

Maybe they can help move the houses out there by giving away one of those SUVs nobody wants to buy with each one purchased, and keep defaults down, so the folks'll still pay their taxes and the cities can make those bond payments.

Maybe I've got this wrong, but I thought that the fundamental assumption behind mean reversion was that the world hasn't fundamentally changed. If the variables that affect price are essentially unchanged, then mean reversion should kick in.

Maybe things haven't changed permanently, but the financial factors that caused the cracks that were heard round the world in the CDO business haven't gone away. Just because the Saudis aren' shovelling money into the banks this week and no major brokerage houses have imploded so far this quarter, I'm not sure we're out of the woods yet.

I think we may end up wandering around in here for a while