A Unique Muni ETF (PRB)

We live in interesting times. Despite hundreds of billions in government stimulus, the markets could not be saved. Though all the king’s horses and all the king’s men attempted to piece together some confidence in the indexes, it wasn’t enough. The Dow and S&P are in the process of taking out their January lows. Where and when stocks will find stability is anyone’s guess.

Safe Alternatives in Risky Environment

With stocks and equity-based ETFs struggling to find momentum, everyone is scanning the horizon for safety. As always, cash is an attractive option. There’s nothing like having a bank statement showing a nice, steady balance. For those who are more comfortable with a safe full of hundred-dollar bills, we understand the sentiment. Our recent ideas, Merger Fund (MERFX) and Pimco Total Return Fund (PTTDX) are a step out on the risk scale but are good ideas too.

However, we think you should consider another option as well. There are several reasons to consider certain municipal bonds. For one, they’re tax-advantaged. Municipal bond interest payments are not taxed as income at the Federal level. In many cases, munis are not taxed on the state or local level either. In addition, municipal bonds stand to gain from a stimulus package in the next few years. As the stimulus package emanates from Washington, that money will head to public works projects. This will trickle down to state and local governments, and consequently municipal bonds should get a nice bump.

But What About Default Risk?

You may be wondering, “what about muni risk”? Didn’t Arnold the Governator just say California will need Federal aid to stay solvent? Doesn’t that problem affect city and county governments too? We are well aware of the default risk of municipal bonds. When individuals and businesses go under, the tax base evaporates leaving bondholders holding the bag. This can be a big problem. Nobody is interested in loaning money to Los Angeles only to have Los Angeles not pay it back.

However, there is a unique type of municipal bond that is virtually untouched by the normal risks associated with munis. They’re called “pre-refunded” municipal bonds. These bonds are used to buy back previous debt and are backed by U.S. Treasuries. Pre-refunded municipal bonds are both tax-advantaged and backed by the full faith and credit of the U.S. government. Individual investors can now purchase these unique bonds via a new ETF:

Market Vectors Pre-Refunded Municipal Index Fund (PRB)

According to PRB’s issuer, these pre-refunded bonds “have been refinanced by their issuers, and their principal and interest are secured by Treasury obligations”. This ETF is for the risk-averse investor who is still looking for a small gain on his investment. We first reported about this ETF here. Other important stats: the average duration of the bonds held in the ETF is 3.5 years and the expense ratio is 0.24%. We’re not talking a big money making opportunity here, but neither are we talking big risk.

It should be noted, PRB is a brand new ETF. The average volume is 20,000 shares per day and is still not as liquid as many bond-based ETFs. But we like the issuer, and we like the idea. Pre-refunded munis are a low-risk way to buy state and local debt and get tax advantages to boot. If you want to take advantage of the opportunities in municipal bonds and still get Treasury-like protection, go with PRB.

All the best.