Colby Bullish On Municipal Bonds For Rest of 2012

Despite precarious financial positions for several large U.S. states and an increased number of municipal bankruptcies, ETFs tracking municipal bonds have been stellar performers in 2012. Jim Colby, portfolio manager and senior municipal strategist, responsible for Market Vectors municipal bond investments, expects the ebullience to continue.

"I believe the continued value proposition embedded in municipal yields nominally higher than those of treasuries has attracted both individual and institutional buyers," Colby said in his weekly research note on muni bonds.

Indeed, it has been a combination of high yields and relatively low default rates that have driven investors to muni bond ETFs. The Market Vectors High-Yield Municipal Index ETF (NYSE:HYD), which has almost $896 million in assets under management, has surged 10.5 percent year-to-date. HYD pays a monthly dividend with a 30-day SEC yield of 4.82 percent and a trailing 12-month yield of five percent.

Other high-yield muni bond funds have gotten in on the act as well. The SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSE:HYMB) has jumped 9.44 percent this year. With almost $144 million in AUM, HYMB features a 30-day SEC yield of 4.53 percent.

Colby notes declining yields on muni issues have bolstered year-to-date returns and helped drive inflows.

"Through September, municipal mutual funds and ETFs have witnessed 43 consecutive weeks of positive cash inflows," Colby wrote in the note.

In theory, an elevated number of municipal defaults should be having an adverse impact on muni bond ETFs, but that has not been the case. One fact that may be keeping ETFs such as HYD and HYMB steady is that default rates are still not at troublesome levels. Arguably, the default risk in the muni bond market is overstated. Colby noted in an interview earlier this year with Benzinga that muni bonds are a $3.7 trillion marketplace, but only 2% of that number trades on any given day

In that interview, he said "less than one half of one percent" of rated bond issues default.

Even the iShares S&P California AMT-Free Municipal Bond Fund (NYSE:CMF), which focuses on muni issues from financially-challenged California, has soared 5.2 percent this year. California issues also account for 22 percent of HYD's weight. The Market Vectors Intermediate Municipal Index ETF (NYSE:ITM) is another example of an ETF heavy on California issues that has thrived despite the negative headlines flowing from the nation's largest state.

ITM has trailing 12-month yield of almost three percent and has risen nearly four percent this year despite a 15 percent allocation to California.

Looking ahead, Colby's forecast is bullish, but he cautions investors that there are potential issues to be aware of.

"I believe we can expect continued good performance but with the following two caveats: (1) political risk in the form of potential changes to, or elimination of, the tax-exempt nature of municipal interest, and (2) credit deterioration resulting from weak underlying economics. Either could have an adverse impact on the market," he wrote.

For more on muni bond ETFs, click here.