Muni Bonds: Muni Bond Plunge Begins…

| November 19, 2010 | 0 Comments

Is the municipal bond market on the verge of collapse?  If recent trading activity is any guide, it certainly looks like it.

Over the past couple weeks, muni bonds have suffered their worst decline in almost two years.  Take a look at a chart of the iShares S&P National AMT-Free Municipal Bond Fund (MUB).

MUB is a good proxy for the overall muni bond market.  The ETF holds more than 30% of all muni bond ETF assets.

As you can see, MUB has taken a swan dive off a very steep cliff.  Since November 8th, MUB is down 4%.  And it’s down from a peak of around $107 set in August by a staggering 5.6%.

If you’re not a muni bond investor, you might think these percentage declines don’t sound too bad.  But they are.  It’s like a 600 point drop in the Dow.

Those of you depending on muni bonds for income know exactly how big a drop this is.  And I’m sure many of you are shaking in your boots.

But not to worry… I’ve got an idea below to help you navigate the rough waters.

Before I get to that, however, let’s tackle the question on everyone’s minds… Why are muni bonds plunging in value?

I see three major catalysts.  And they’re all combining at once to crush muni bond values.

The first catalyst is a huge supply of new issues coming to market. This week’s newly issued municipal debt was the highest in at least seven years.

Cash strapped states and cities are trying desperately to raise funds. Heavy spending and a big drop in tax revenues have many teetering on the brink of default.

The poster child for this situation is California.

The Golden State is looking at a potential $25 billion budget shortfall through mid-2012.  To raise much needed cash, the state tried to sell a whopping $10 billion worth of revenue anticipation bonds this week.

(Normally, you see around $20 billion in new issues nationwide for a whole month.)

However, concerned about the state’s ability to make future interest payments, investors only bought 60% or $6 billion worth.

That brings us to catalyst number two.

Worries about muni bond issuers defaulting on their interest payments are keeping a lid on demand.  Investors are not automatically buying up new paper like they have in the past.  So, if issuers want to sell bonds, they’re going to have to offer investors higher interest rates.

And this is scaring some investors out of muni bonds entirely.  For example, investors last week pulled $115 million out of municipal bond funds.  It was the first weekly outflow in seven months.

Why were they selling?

Simple.  You see, if issuers starting offering new bonds with higher interest rates, the value of existing bonds at lower rates will drop.  And if this is just the beginning of a longer term trend, muni bond values could plummet much further.

The third catalyst is the Fed’s QE2.

QE2 involves the Fed buying $600 billion worth of Treasuries through June 2011.  The purpose of QE2 is to stimulate economic growth by keeping short-term interest rates low.

But the strategy is having an unintended negative impact on long-term muni bonds.

Here’s why…

The Fed’s only buying shorter-term Treasuries.  As a result, yields on 30-year bonds are moving rapidly higher.  And, since longer term muni bond yields tend to move in tandem with long-term Treasury yields, they’re moving higher as well.

This action in turn is pushing long-term municipal bond prices lower. Remember, bond prices move in the opposite direction of bond yields.

When you examine the effects of all three catalysts combined, it certainly looks like a perfect storm is brewing in the muni bond market.  The recent plunge in muni bond values could be just the first leg down.

Many investors are counting on the tax-free income generated by muni bonds.  And given the recent turmoil, you’re wondering what to do now!

Here’s a practical way to minimize the current downside risk in munis…

Stick to shorter-term maturities.

Whether you buy individual bonds or muni bond funds, shorter-term securities will hold their values better than longer-term bonds.  A quality short-term muni bond fund is the SPDR Nuveen Barclays Capital Short-Term Muni Bond Fund (SHM).

SHM has $1.3 billion invested primarily in high investment grade munis.  The portfolio’s average maturity is short at just over three years.  The cost of ownership is very low with an expense ratio of a mere 0.20%.  And the fund’s down just 1% in the recent selloff.

What’s more, the fund boasts a current yield of 4.19%.  (Don’t forget the interest is exempt from federal taxes and some state taxes.)

Clearly, it’s time to exercise caution when investing new money into munis.  Take a closer look at SHM for your portfolio.  It’s a safer way to generate tax-exempt income in today’s volatile muni bond market.

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Category: Bonds

About the Author ()

Robert Morris is the editor of Penny Stock All-Stars, an investment advisory focused on discovering small-cap and micro-cap stocks that are destined to become the market’s next Blue Chips. The Wall Street veteran and small-cap stock specialist is also a regular contributor to Penny Stock Research. Every week, Robert shares his thoughts with our readers on a variety of penny stock-related topics. In addition to Penny Stock Research, Robert also writes frequently for two other free financial e-letters, ETF Trading Research and the Dynamic Wealth Report. He’s also the editor of two highly successful and popular investment advisories, Biotech SuperTrader and China Stock Insider.

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