(07/26/13) Detroit and Your Muni Bonds

Detroit filed for Chapter 9 bankruptcy in federal court, laying the groundwork for Michigan's largest city to receive debt relief. So what does this mean for muni bond investors, asks S&P Capital IQ's Todd RosenBluth in Market Scope.

While a rash of filings around the country appears unlikely—since each municipality faces a different set of challenges and opportunities—we think it is reasonable for investors to need to understand what this means for their portfolios.

Investors choose municipal bond ETFs for a variety of reasons, include tax-exemption status and the steady stream of income supported by strong credit quality, yet the asset-class experienced outflows in June and the beginning of July.

Yet, the credit quality remains strong. Indeed, defaults in 2011 and 2012 for municipal bonds within the S&P Municipal High Yield Bond Index were lower than the default rate of the U.S. speculative grade corporate bonds.

Further, according to the US Census Bureau, state and local tax collections have experienced steady growth since 2010.

So what does this mean for muni-bond ETF investors? Well, according to S&P Capital IQ research, the average tax-free ETF has 94% of assets invested in investment-grade bonds. So the strong credit quality for muni-bond ETFs should give investors some confidence.

How about exposure to the state of Michigan, since the troubles in Detroit could negatively impact other Michigan bonds? Well, of the ten largest multi-state municipal ETFs, just two of them have more than 3.5% exposure of assets to the state.

PowerShares VRDO Tax-Free Weekly Portfolio (PVI) recently had 5.5% exposure to Michigan, while PowerShares Insured National Municipal Bond Portfolio (PZA) had a 4% weighting in such bonds.

Assets were spread out across states such as New York, New Jersey, and Pennsylvania, which have high investment-grade state ratings. This is evident when we look at the underlying holdings to form an S&P Capital IQ ETF ranking.

PZA had 83% of its assets in bonds with AA ratings, while PVI had 54% of its bonds with AA ratings and 14% in AAA ratings. This relatively strong credit quality, combined with analysis of the yield, liquidity, and costs of the ETF, help to drive the top rankings from S&P Capital IQ. (We rate both PVI and PZA as overweight.)

Equally important is that this mid-single digit exposure is limited to a few funds. iShares National AMT-Free Muni Bond ETF (MUB), SPDR Nuveen Barclays Short Term Municipal Bond ETF (SHM) and SPDR Nuveen Barclays Municipal Bond ETF (TFI) are the three largest muni ETFs with over $1 billion in assets each.

According to S&P Capital IQ ETF reports that list the ETFs' exposure to the ten largest states, Michigan is either not in the portfolio or there is less than 3% exposure.

While Detroit is in the news for understandable credit quality reasons, we think investors can still look to municipal bond ETFs for stable tax-exempt income.