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Merrill Lynch sees opportunities in Muni's

As the credit crunch has unfolded, we have seen municipal bonds fall in value as bond insurers have weakened and concern mounts that mortgage problems will impact the ability of municipalities to collect tax assessment revenues.

Merrill believes this is somewhat overdone and that the entire municipal bond sector has been tarnished though only isolated instances of problems are likely to occur. Without more precise risk assessment to identify those municipalities that will or will not suffer, investors will be throwing out the baby with the bath water. This implies that national muni closed-end bond funds are selling at deeper than average discounts to their net asset values.

The chart below shows the yield ratio between AAA-rated municipal bonds and 10-year Treasuries. The ratio is currently at a multi-year high. Merrill expects the 10-year Treasury yield to fall to 3.5% by mid-2008, supporting an expectation that the relative yield of munis will remain at a higher than average level.


Yield ratio: Munis vs. Treasuries, click for larger image.
Other than buying bonds outright, the traditional way to invest in munis is via mutual funds or closed-end funds. There are many choices in these vehicles and all the financial portal websites provide extensive information.

Less well know is the fact that there are a few ETFs available in this sector.

VanEck offers the MarketVectors Intermediate Municipal Index ETF (ITM). It is a national muni fund based on the Lehman Brothers AMT-Free Intermediate Continuous Municipal Index. This index is a market value weighted index designed to replicate the price movements of medium-duration bonds (6-17 year maturity). Other characteristics of the index: bonds are rated investment grade, are AMT-Free, have an outstanding par value of at least $7 million, are issued as part of a transaction of at least $75 million and are fixed rate. This ETF was only launched this month so there is little history. Volume is very light and yield has not been provided. You can read more about it here.

BlackRock Municipal Bond Trust (BBK) has been around for a while but it is allowed to invest in lower quality bonds, less than AAA-rated. A brief description can be found here.

PowerShares is in the process of rolling out a selection of new ETFs based on two muni indexes created by Merrill Lynch. One is an insured portfolio, the other isn't. Otherwise, both will track tax-exempt long-term debt publicly issued by U.S. municipalities in the U.S. domestic market, will exclude single- and multi-family housing bonds, tobacco bonds and all securities subject to AMT (Alternative Minimum Tax). Read more about them here.

If you're looking for yield with moderate risk, now might be the time to look into muni's.

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