Do Not Overlook Municipal Bonds for Income

The fixed income market continues to baffle even the smartest people on Wall Street. If the stock market is near an all-time and the Fed taper is over, why would investors continue to pour money into U.S. Treasuries and corporate bonds?

That is a great question that has been debated for the last couple of years as it has become apparent that the Fed will eventually be forced to increase the Fed Funds rate. When that happens, consensus is mid-2015; it should send bonds lower and yields higher. In the meantime the iShares Barclays 20+ Year Treasury Bond ETF TLT hit a new two-year closing high this week as money continues to flow into low-yielding bond ETFs.

While the U.S. treasury trade may be getting very long in the tooth there is another area within fixed income that may be able to hold up better when interest rates start to increase. The municipal bond market offers lower yields than corporate bonds, but carry tax advantages that the wealthy tend to prefer.

There are two municipal bond ETFs that cover the gamete of the asset class that investors should consider.

The Market Vectors High Yield Municipal ETF HYD is made up of 779 municipal bonds, with 75 percent being non-investment grade and the other 25 percent considered investment grade bonds. The bonds in the portfolio are distributed across more than 20 states and 11 sectors. California, New York, and Texas are the most heavily weighted states while IDR/PCR and health care facilities are the most weighted sectors.

The ETF is up 10 percent year to date and 3 percent over the last six months. The 30-day SEC yield is 4.41 percent, however the tax equivalent yield for someone in the highest tax bracket (39.6 percent) is 7.3 percent. Making the ETF extremely attractive for high-income earnings that need an investment for a taxable account. The ETF has an expense ratio of 0.35 percent.

The iShares National AMT-Free Muni Bond ETF MUB provides investors exposure to more than 2,400 municipal bonds. The bonds arte distributed across 44 states and 31 sectors. The top weighted states are California at 22.6 percent, and New York at 20 percent. While the top weighted sectors are various purposes at 23.6 percent, and transportation at 22.5 percent.  MUB is up 6 percent year to date and up 2 percent over the last six months. The 30-day SEC yield is 1.61 percent and the tax equivalent yield is 2.85 percent. The ETF has an expense ratio of 0.25 percent.

The reason HYD has a higher yield is due to the fact it has a large exposure to bonds that are rated below investment grade. These bonds are considered higher risk therefore investors demand a higher monthly interest payment. With higher risk comes higher reward.