The flight from risk hit muni bonds, too

The $2 trillion market for tax-free bonds, generally those issued by states, cities and other municipal government bodies, has long been considered a sleepy corner of the fixed-income world. And it’s true that many buyers of muni bonds are wealthy senior citizens who have no interest in trading or doing much of anything beyond collecting their tax-exempt interest. But in recent years, the muni market has been invaded by a host of racier investors, mainly hedge funds, seeking to buy up bonds and repackage the cash flows. These kinds of traders try to profit from the difference in yield between short and long-term rates as well as the difference between the taxable and tax-exempt markets. And that makes the muni market a whole lot less sleepy than it used to be.

In fact, as the InvestmentNews web site reports today, munis sold off dramatically last month as the creators of some of those repackaged portfolios had to unwind in a hurry. And the muni market rarely works well when under pressure. Prices plummeted, forcing yields above 5%. In the middle of August, yields on tax-free bonds actually rose above the yield on Treasury bonds, which obviously are subject to taxation, a once in a blue moon phenomenon that reliably signals a great muni buying opportunity. The market has recovered a bit, although yields remain solidly in bargain territory, and an overhang of postponed new issues from August could hit prices again over the next few weeks.

Apropos of last week’s post on the creation of the first muni bond exchange-traded funds, there’s now a simple way for ordinary investors to get in and out of munis. Barclays and State Street have introduced similar funds with very low expenses that pay tax-free interest and track diversified muni market indexes. Barclays’ fund, trading under the symbol “MUB,” charges just 0.25% and is expected to yield 4.42%. State Street’s fund, under the symbol “TFI” starts with a yield around 4.60%. Rudy Aguilera over at IndexUniverse listened in on both sponsors’ introductory conference calls and has more details in this blog post.

There are inexpensive mutual funds to consider as well, although ETFs would make a better vehicle for a short-term investment. Most mutual funds frown on short-term trading and impose penalties. Vanguard’s national muni bond fund (VWLTX), for example, features a management fee of only 0.16% and yields 4.20% currently. It limits exchanges and sales for 60 days after purchase. It’s also actively managed and has slightly trailed the Lehman Brothers 10-year muni index over the past 3, 5 and 10 years. Over the past year, Vanguard trailed the index by a more significant margin of almost a full percentage point. And most other firm’s muni mutual funds have far higher expenses.

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