Last week I received an e-mail solicitation that was both hilarious and sad. It came from a broker trying to sell municipal bonds from Illinois. He touted them as “investment grade” and was impressed by the tax-free 5.6 percent yield.
This is absurd, of course, as you know if you’ve been reading Money and Markets regularly. Cities and states everywhere are in dismal financial condition. Illinois is among the worst of the lot. A ratings agency called Illinois bonds “investment grade” only because the entire issuer-financed ratings system is corrupt.
Needless to say, I didn’t take the bait.
Here is a tip that will serve you well in your investing: If an offer sounds too good to be true, it probably is. Right now, just about anything that offers a “safe” 5.6 percent yield is either a complete scam or far riskier than it looks on the outside. Don’t fall for it.
Now I’m not saying that all municipal bonds are always useless. They can make sense for wealthy people in high tax brackets. They may even fit as a small slice of a retired person’s income portfolio.
But you need to be aware of the risks, because …
Not All Muni Bond ETFs
Are Created Equal
Like they do in many other segments, exchange traded funds (ETFs) are often the better way to go if you want to own municipal bonds. You get the advantages of diversification and liquidity in one package.
Why is this important?
The idea of a local government going bankrupt used to be unthinkable. For states, it has long been thought impossible. But now more than ever, municipal bonds carry significant credit risk.
The governmental bodies — such as cities, states, school districts, and water departments — that issue these bonds are suffering in this weak economy. Often they’re saddled with unsustainable union contracts and huge pension obligations.
So what happens if, in your quest for lower taxes and higher yields, you own a portfolio of muni bonds from a troubled state like Illinois — which then goes bankrupt? Instead of a juicy yield, you may find you’re holding a massive loss.
ETFs offer at least a partial solution to this problem — or at least some ETFs do. Muni bond ETFs run the gamut from highly speculative to fairly safe, along with everything in between.
First, let’s take a look at a couple of ETFs I wouldn’t touch with a ten-foot pole …
Muni ETF #1 to Avoid:
PowerShares Insured National Muni Bond (PZA)
Ahh, that comforting word “insured.” No need to worry — the insurance company is there to take care of you. Well, no, not exactly.
Bond insurance is supposed to protect investors against default. If the issuer can’t pay you back, the insurance company will. That’s assuming it even exists when the bill comes due.
As Martin pointed out earlier this week, two of the largest bond insurers (AMBAC and FGIC) have already gone bankrupt. And the other big one, MBIA, is on the edge.
PZA specializes in these kind of muni bonds — the ones that look safe but really aren’t. Even more amazing, insured munis tend to pay below-average yield because of the supposed “guarantee.” For some reason, people believe it. They’ve made PZA one of the largest and most actively-traded muni bond ETFs.
My take: PZA is fool’s gold. Don’t be fooled by the glitter. Just keep moving downstream.
Muni ETF #2 to Avoid:
Market Vectors High-Yield Municipal (HYD)
In bond lingo, “high-yield” is a polite way of saying “junk.” HYD is a junk-muni ETF. It holds a portfolio of bonds that can’t qualify as investment grade even under the laughably low standards of the major rating agencies. They really are junk!
Because it is an ETF, HYD is diversified among many different junk munis … but they’re still junk. They have high yields for a very good reason: These bond issuers are more likely to default.
Sometimes the risk of default is outweighed by higher potential returns. In my opinion, now is not one of those times. Stay away from HYD.
Now, let’s spotlight …
A Muni ETF That Is Worth a Second Look:
Market Vectors Pre-Refunded Municipal (PRB)
A “pre-refunded municipal” is an interesting little niche. When interest rates drop, borrowers like to refinance. You may have done this with your home mortgage. However, unlike your mortgage, most muni bonds can’t be retired just because they’ve been replaced by new, lower-rate bonds.
So states and cities use the proceeds from a new bond sale to buy Treasury securities matched to the “call date” of the original bond. These are then held in escrow to pay off the original bonds.
That means if you own those original bonds, what you really own is a portfolio of U.S. Treasury securities. The yield is still tax-free because they are wrapped inside a municipal package. But you are no longer exposed to the local government’s default.
PRB holds a portfolio of these bonds.
Right now the average maturity is 3-4 years. The yield, which is free of Federal taxes, is about 1.1 percent. If you’re in the top tax bracket (35 percent), the taxable equivalent yield is around 1.7 percent. That’s hard to beat at such a low level of risk.
As you can see, muni bond ETFs come in all shapes and forms. Some are potentially very dangerous. Others, like PRB, can be very attractive. So do your homework before jumping in.
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