Friday, May 20, 2011

Muni bond redux

Late last year I mentioned the relative thrashing muni bonds had experienced.  Fast forward to today and the mass defaults as predicted by Meredith Whitney are not occurring and muni bonds have experienced a nice rebound.  Let's look at some charts:

The ETF's MUB and IEF are great for comparing the two sectors as they have almost the same duration of 7.43 vs. 7.24. While they are not precisely the same (MUB's bonds are more smeared out along the maturity curve while IEF's are very compact) it is good enough for this discussion.

As you can see MUB is now outperforming IEF on a relative basis and the yield one receives from MUB remains higher than IEF with an estimated yield to maturity of 3.30% versus 2.86% Usually municipals bonds yield less than treasuries due to their tax free income but not right now.  Assuming a return to 'normal' with muni bonds yielding 80% of treasuries you'd need MUB to increase by approximately 7.5%

[The math:  80% of IEF's ytm = 2.29%
MUB yield change (3.30 - 2.29) * duration of 7.43 = 7.50 ]

This does not include the tax free coupon one would receive while you wait for the trade to complete and also assumes treasury rates remain stable.  I'm of the opinion treasury rates will also drop in the near future so you'd gain there as well.  All in all a relatively low risk / low reward trade but considering the equity markets have been going nowhere for a couple months I'll take it.  MUB is also starting to outperform SPY on a relative basis as well, go figure...

Reminder: I don't manage your money and this is not a complete part of my investment portfolio. I may not tell you when I close out the position.  This should not be construed as investment advice as I do not know your tolerance for risk, tax situation, need for income, etc. 

Disclosure: Long MUB in both personal and client accounts.

Additional reading:
Ishares MUB etf detail
Ishares IEF etf detail
Business Insider
JPMorgan's comments

Note: Another possible reason why MUB is outperforming is the light issuance schedule for muni bonds right now. This may be due to the previous rush to market while Build America Bonds were still possible before the 12/31/10 deadline or the current high relative yield environment for muni bonds.
Bond Buyer article #1  & Article #2  (ht MuniLass)

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