The U.S. municipal bond market, which saw volatile trading in 2013, seems to be finally having its good days. Munis have recovered some of the losses from last year and are finally trading in the green.
In fact, the $3.7 trillion municipal market gained in March for the first time in six years, according to Bloomberg. The munis market has gained around 3.8% during the first quarter this year, marking it as the best start to a year since 2009. During the first quarter of 2009, munis had clocked a gain of 4.4% (read: Three Municipal Bond ETFs for 2014).
Demand – supply imbalance seems to be the primary reason for these rebounding returns in this market. While the demand for munis is robust this year, shortage of supply is driving the gains higher. Total issuance for municipal bonds during the first quarter of 2014 stood at $60.3 billion, the slowest since the second quarter of 2011.
Though this seems to be a major force for first quarter returns, improving fiscal conditions in many localities and low interest rates are also favoring municipal bonds returns.
Rising interest rates, as a result of Fed taper threats, Detroit's bankruptcy filing and the concerns on the financial soundness of Chicago, California and Puerto Rico were some of the culprits for the poor performance of munis last year.
Munis are bonds issued by city, state and country governments to raise money for different community projects including highways, new schools, or hospitals. Usually the interest income from munis is exempt from federal tax and may also avoid state taxes.
However, in case the underlying investment planned to be financed by the municipal bond issue fails to provide any significant benefit to the general public, bonds can lose their tax status and the Federal government then levies taxes on the interest on the bond issue.
Amid these restrictions and declining costs for taxable debt, many issuers are issuing taxable corporate bonds. Issuers are thus favoring the flexibility of selling munis without the tax exemption (read: Three Biggest Mistakes of ETF Investing).
These taxable munis hold an appeal for overseas buyers over the tax-free munis and are continuing to attract international interest ever since its debut in 2009. Moreover, these bonds have also received appreciation among U.S. investors for their wider appeal.
With improving fiscal conditions, low chances of interest rates rising this year and taxable munis gaining popularity, a look at a top ranked ETF in the Municipal Bond space would be the best option to capture the uptrend, and to reduce risks for equity heavy portfolios:
About the Zacks ETF Rank
A look at top ranked Municipal Bond ETFs can be done by using the Zacks ETF Rank. This technique provides a recommendation for the ETF in the context of our outlook of the underlying industry, sector, style box, or asset class. Our proprietary methodology also takes into account the risk preferences of investors as well.
The aim of our model is to select the best ETFs within each risk category. We assign each ETF one of the five ranks within each risk bucket. Thus, a Zacks Rank reflects the expected return of an ETF relative to other ETFs with a similar level of risk.
Using this strategy, we have found one ETF Ranked 2 or ‘Buy’– SPDR Nuveen Barclays Build America Bond ETF (BABS - ETF report) – which we have highlighted in greater detail below (see all Municipal Bond ETFs here).
BABS in Focus
Launched in May 2010, the fund tracks the performance of Barclays Build America Bond Index.
Build America bonds first made their appearance following the 2008 financial crisis. These bonds were introduced to stimulate investment in infrastructure projects in the economy such as public schools, roads, transportation infrastructure, bridges, ports and public buildings.
Build America bonds typically pay taxes closer to taxable corporate bonds and the interest received on these bonds is subject to federal income tax and may be subject to state income tax (read: 5 Long Term ETF Buys for Your Roth IRA Contribution).
The fund holds a basket of 184 bonds and targets the long end of the yield curve. The fund holds longer maturity bonds and has an average maturity of 25.74 years with modified adjusted duration of 12.60 years. The 30 Day SEC yield for the fund stands at 5.12% with yield to maturity at 4.63%.
The fund seems to be well diversified among its holdings, except for the top two holdings – California and New Jersey munis – which together account for around 14% of the total assets.
Also, the fund assets are diversified across various states, with bonds issued by California (35.44%) taking the top spot, followed by New York (15.09%) and Texas (10.20%).
After slumping 2% in the past one year, BABS has retuned 9.2% since the start of the year and has been a top performer in the national munis space. Moreover, the fund has also performed well over the past three years, returning 39%. The fund charges 35 basis points a year and manages an asset base of $52.6 million, and it may be an interesting low risk pick for investors seeking a muni bond play at this time.
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