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Are Municipal Bond Defaults the Next Financial Crisis?

etfguide - July 7, 2009 - Ron DeLegge

SAN DIEGO ( – The usually quiet and calm municipal bond market is looking anything but. Just last week, Governor Arnold Schwarzenegger of California declared a fiscal emergency for the state. What impact will this have on municipal bond investors? For sure, it would be a grave mistake to conclude California’s financial problems are isolated.

Municipal bonds are debt obligations issued by states and local government to finance various projects and services for the benefit of their communities.

California’s $24.3 billion deficit is a clear signal the financial health of state and local government is rapidly deteriorating around the country. While state governments have the power to raise taxes, they don’t have the ability to print money or manipulate interest rates like the federal government. Do you own municipal bonds or bond funds concentrated in geographically troubled regions? If you do, right now is the time to be on high alert.

Bleak Outlook
“At least 48 states addressed or are facing shortfalls in their budgets for the upcoming year totaling $166 billion or 24 percent of state budgets.” observes the Center of Budget and Policy Priorities. The only two states not facing budget shortfalls are Montana and North Dakota. A decline in tax receipts has exacerbated falling state revenues and their rising debt loads.  

Is there light at the end of the tunnel?

Moody’s, which mis-rated billions in garbage mortgage debt, assigned a negative financial outlook on the creditworthiness of all U.S. municipalities in April. While it’s true that debt rating agencies don’t hold the same level of credibility or respect they once had, it would be fool-hearted (not to mention bone-headed) for munibond investors to ignore the warning signs.

Let’s examine a few key munibond ETFs.

iShares S&P National Municipal Bond Fund (NYSEArca: MUB)
With $1.2 billion in assets, MUB is one of the largest munibond ETFs. The fund’s performance and yield is linked to the S&P National Municipal Bond Index which is comprised of municipal bonds from U.S. state, city and local governments.

In order to be included within the fund’s index, bonds must have minimum rating of BBB- by Standard & Poor's, Baa3 by Moody's, or BBB- by Fitch. Each bond is denominated in U.S. Dollars and must have no less than $50 million in outstanding par amount. This index is market value weighted and holdings are updated on the last business day of each month. Munis from Puerto Rico, Guam, and U.S. Virgin Island territories are also included.

Year-to-date, MUB has gained 1.76% and currently carries a yield in the vicinity of 3.6%. In 2008, MUB declined 0.98% and the fund’s annual expense ratio is 0.25%. 

Market Vectors Pre-Refunded Municipal Index ETF (NYSEArca: PRB)
This particular munibond ETF was just introduced in early February and is benchmarked to the Barclays Capital Municipal Pre-Refunded–Treasury-Escrowed Index. The index is market-size weighted comprised of pre-refunded and escrowed-to-maturity municipal securities backed by an escrow or trust account containing obligations that are directly issued or unconditionally guaranteed by the U.S. government.

The fund’s index excludes pre-refunded bonds backed by agency securities or third-party investments such as CDs. Bond maturities generally range from 1-to-30 years. PRB’s annual expense ratio is 0.24%.

PowerShares VRDO Tax-Free Weekly Portfolio ETF (NYSEArca: PVI)
This munibond ETF is benchmarked to the Thomson Municipal Market Data VRDO Index. The index is designed to track the performance of a pool of short-term, tax-exempt Variable Rate Demand Obligations (VRDOs) issued by U.S. municipalities. VRDOs are generally high-quality, floating-rate bonds that provide investors with tax-exempt income in a short-term time frame. VRDOs are always purchased at par. When they are put back to an investment dealer, the investor receives par plus accrued interest. Yields are generally reset on a weekly basis.

Over the past year, PVI has gained 2.72% and currently carries a yield in the vicinity of 2.7%. In 2008, PVI gained 0.44% and the fund’s annual expense ratio is 0.25%. 

SPDR Barclays Capital California Municipal Bond ETF (NYSEArca: CXA)
This municipal bond ETF seeks investment results that correspond to the performance, before fees and expenses, of the Barclays Capital Managed Money Municipal California Index. The index tracks publicly traded California municipal bonds that cover the U.S. dollar denominated California tax exempt bond market, including state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

Year-to-date, CXA has gained 2.25% and currently carries a yield in the vicinity of 4.2%. In 2008, CXA declined 3.5% and the fund’s annual expense ratio is 0.20%. 

iShares S&P New York Municipal Bond ETF (NYSEArca: NYF)
This munibond ETF follows the S&P New York Municipal Bond Index. The index measures the performance of the investment grade segment of the New York municipal bond market and is a subset of the S&P National Municipal Bond Index which comprised of municipal bonds issued in the state of New York. Each bond must have a rating of least BBB- by Standard & Poor’s and must have a minimum par amount outstanding of $50 million. In addition, each bond must have a minimum term to maturity and/or pre-refunded or call date greater than or equal to one calendar month to be included in the index. The index is market value weighted. The securities are updated on the last business day of each month.

Year-to-date, NYF has gained 4.73% and currently carries a yield in the vicinity of 3.7%. In 2008, NYF declined 2.02% and the fund’s annual expense ratio is 0.25%. 

Your Munibond Strategy 
A financial crisis in the $2.5 trillion munibond market has national implications. It will impact the federal government, bond underwriters, issuers and rating agencies. It will also impact munibond insurers like Warren Buffett’s Berkshire Hathaway Assurance Company (BHAC).

In April, we warned investors about the unraveling municipal bond market and the financial danger of total collapse. In the Weekly Pick section of our ETF Profit Strategy Newsletter we stated, “Investors should be particularly concerned with rising defaults of munibonds located in economically depressed U.S. regions.” We also warned, “Do not be seduced by yields nor by a historically calm munibond market.”

Do you own bonds or a bond fund that are concentrated in municipalities on the brink of bankruptcy? How should you play the munibond hurricane? If you own municipal bonds or any munibond funds, you owe it to yourself to revisit your investment strategy.

Performance figures quoted through July 5th, 2009 market close

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