Insulating Your Portfolio with the Pre-Refunded Bond ETF

Right now, many investors simply want to protect what they have in their ETF portfolios. If they get any return, all the better. But are you armed with the knowledge you need to keep yourself safe?

Protecting yourself boils down to tried-and-true advice: diversify, and don’t reach for yield. Municipal bonds, in particular, have garnered a lot of interest. There is risk of default when it comes to them, but these defaults have been very rare. They do happen, though: in 1994, voters in Orange County, California, rejected a tax hike and forced bondholders to wait an extra year to get their money back, which they did, with interest.

Many states are in dire straits right now, with plunging tax revenues, higher unemployment claims and a host of other fiscal troubles, says Scott Woolley for Forbes. How can you minimize default risk?

• History suggests that it’s better to own bonds by a state instead of by an obscure town or sewer authority; the government is unlikely to let an entire state’s economy go bust.
• States have been free to set their own rules for how to deal with creditors - find out what the rules are for the state you’re investing in.
• Find pre-refunded bonds - these are bonds that issuers plan to call and have fully collateralized with Treasury notes.

Pre-refunded municipal bonds are among the highest quality muni bonds available. Income and principal are normally secured by an irrevocable trust of U.S. Treasury securities, so the payment isn’t dependent on the revenue stream or tax collections of the issuing municipality, according to a report on the bonds from Morgan Stanley.

These bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. Once refinancing is completed, the issuer uses the proceeds of the new issue to purchase collateral. The collateral income is then used to pay interest and principal on the original debt until the bond is called.

Market Vectors Pre-Refunded Muni ETF (PRB) is a basket of pre-refunded bonds with an average duration of just over three years and pays a yield (net of expenses) of 1.2%, which is equivalent to the pretax yield on three-year Treasury notes. The fund launched just last month.

• Market Vectors Pre-Refunded Muni ETF (PRB): down 1.3% for one week; expense ratio is 0.24%