State of California. Finally some good news – the state recently received a credit rating upgrade by S&P to A from A- following news that its budget would have a surplus this year.  The combination of spending cuts and higher state income tax rates resulted in a favorable outcome for creditors. Bonds issued by the state traded at tighter spreads following the news.

So how should a muni investor think about these events? Well, if you’re concerned about downgrades and bankruptcies, one solution is to invest in a high quality, diversified municipal bond fund. For example, all of the iShares municipal bond ETFs hold only investment grade bonds – which basically means they do the filtering for you. If an issuer gets downgraded to below investment grade (lower than BBB-/Baa3), the bond will be removed from the fund’s index at month-end and rebalanced out of the fund. iShares municipal bond ETFs also are well diversified in terms of issuer type and geography.

Even with these events in the municipal bond market, we still favor the sector. The combination of higher tax rates and lower levels of supply should be supportive of prices of municipal bonds this year.  And relative to other types of debt, municipal bond after-tax yields still look attractive relative to similar credit quality corporate debt.

iShares National AMT-Free Muni Bond ETF

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.