Muni Bond ETFs? Not So Fast

ETF Database's Michael Johnston made the case for three muni bond exchange-traded funds last week, concluding that:

As prices have tumbled in recent weeks, yields on muni bond ETFs have jumped. While this corner of the bond market obviously remains very risky, there are some interesting opportunities that could deliver solid current returns if we manage to avoid a wave of muni defaults.

While municipal bonds are less expensive than they were a few weeks ago, the price decreases are a recent development. Money had been flowing into municipal bond funds for 22 consecutive months through the end of October, but Dec. 8 marked the fifth consecutive week of money flowing out of muni funds. Five weeks of outflows is only a tiny reversal of a 22-month trend of inflows. Combine that with the Federal Reserve busily working to create inflation, and bond prices could have a long way to go before hitting bottom.

But regardless of whether munis are in the beginning of a bear market or are poised to bounce, some actively managed closed-end funds look like attractive alternatives to muni bond ETFs, because closed ends are better able to manage default risk and have higher yields.

Default risk
As an example of default risk, consider the state of Illinois. Illinois is behind on payments to vendors and is trying to work deals with Wall Street investors for them to pay the vendors in exchange for the 1%-per-month late fees and, eventually, payment for the balance. That kind of financial juggling may seem worthy of a junk-status credit rating, but Moody's still rates Illinois with a middle-range investment-grade rating.

Because ETF holdings are selected to match an index, there is no way for a manager to screen for possible rating mismatches and avoid problems or find bargains. Investors pay higher fees for active management, but where markets are in uncharted waters, an experienced hand is worth it. Closed-end funds can avoid these troubled securities to find higher-quality issues.

Higher yields
Many closed-end municipal bond funds can offer higher yields than comparable ETFs both because they use leverage and sometimes trade at a discount to their asset values. Because closed-end funds have a fixed number of shares, the market price can trade at a premium or a discount to the underlying value. An ETF will typically maintain very tight spreads to underlying asset values.

Let's compare the three ETFs from the ETF Database article with some closed-end fund alternatives.

Source: Fund websites.

The funds above should not be considered recommendations. But they are examples of alternatives to muni ETFs, and they demonstrate that ETFs aren't the only way to buy a basket of securities -- or even the best way, in some cases.

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