The stock market is a temperamental beast. Every year, month, week, day and even hour is different than the one preceding it. Long-term 100-year charts clearly show a substantial upward drift in stock prices, however, there are multi-year periods of very little change and even times of bearish, downward movement. If you begin investing in stocks during the start of one of these down cycles, it can take years just to get back to even, and that’s if you had the luck to buy the right stocks. 

The market is littered with the financial corpses of those who went “all-in” during a bearish cycle or bubble burst of a particular sector. One only has to look back as far as the banking crisis of 2007-2008 or the Internet bubble burst at the turn of the century to find stocks of companies that never recovered. Even the broad indexes are well off their all time highs. Plenty of long term investors bought near the top and are still negative overall in their stock portfolios. 

One way to prevent being caught at the wrong time and in the wrong place is by diversification. I don’t just mean sector diversification within the stock market, which is critical, but asset class diversification. This is particularly vital in long-term retirement investment accounts. And I have one asset class in mind that looks like a particularly good bet in today’s environment. 

I’m talking about bonds — specifically, municipal bonds.

While some investors choose to diversify through the commodity or real-estate market, the advent of exchange-traded funds, or ETFs, opened the ability to diversify asset classes with ease within your regular brokerage or retirement account. 

This is also true of municipal bonds. Purchasing municipal bonds has been a time- tested method of diversification. And now, municipal bonds can be purchased in the form of an ETF. Buying municipal-bond ETFs is not only convenient and offers instant diversification within the fund, they also provide a steady, tax-free income stream to the holder (making your effective yield higher when compared to most other dividend paying securities). 

If you decide to purchase a municipal bond directly, you get a semi-annual coupon payment. Instead, the municipal bond ETFs pay out tax-exempt, monthly dividends. This is great for a retirement account. (Imagine being able to draw monthly dividend payments on your investments — much like a regular paycheck. In fact, Amy Calistri’s Daily Paycheck newsletter is built around this very concept). 

While municipal bonds have suffered their share of negative press, low interest rates and shaky economic times, they remain appealing due to their low volatility and steady payouts. Even defaults of cities like Harrisburg, Pennsylvania and Stockton, California did little to dissuade investors out of the market. Municipal bonds are a $3.7 trillion market, but only 2% of the entire market trades on any given day. With this said, less than half of 1% of all rated bonds run into default issues. What I find most appealing is there is little to no correlation between municipal bond issues. In other words, if one defaults, there is little to no chance of the problem spreading to other issues. 

Here are 2 municipal bond ETFs on my radar screen…

1. iShares S&P National AMT — Free Municipal Bond Fund (NYSE: MUB)

This $2.9 billion dollar fund tracks the Standard & Poor’s index of the same name. It trades a healthy average three-month volume of 285,567 shares and offers a yield of 3.2%. The fund is up about 2.5% for the year. Technically, the price is solidly above both the 50 and 200-day simple moving average and trading around $110. The price is about $3 off its early 2012 high of $113, creating a compelling technical case for a buy right now.

2. Market Vectors Long Municipal Index ETF (NYSE: MLN)

This is a smaller sized ETF, with just $78.8 million of net assets. It has returned about 3.2% this year and throws off a yield of 4.3%. The three-month average volume is about 28,000 shares. The ETF tracks the performance of the Barclay Capital AMT- Free Long Continuous Municipal Index. Other than the low trading price of just under $20, the fact that this ETF has heavy exposure to financially beat-up California yet continues to offer solid performance makes it a compelling buy suggestion. Technically, shares are just off of their $20 high and are firmly above the critical 50 and 200-day moving averages. Purchasing this one on a break above the $20 level makes sense.

Risks to Consider: All financial instruments have some risk to the buyer. Municipal default is the primary risk factor in municipal bond ETFs. But as I noted above, defaults have so far been isolated cases and haven’t really affected the broader municipal bond market.

Action to Take –> Every retirement portfolio should be diversified among asset classes to an extent. Municipal bond ETFs can help provide this diversification as well as offset the inherent volatility of a stock portfolio. I like both of the ETFs I mentioned earlier as a part of that strategy.

P.S. — For more income ideas, be sure to read our latest report… The $1,357 Per Month “Daily Paycheck” Strategy.