ETF Expert

Fiscal antics of the Governator and California state legislature aside, municipal bonds have a well earned reputation for being plain vanilla investments purchased by plain vanilla investors to achieve plain vanilla returns. Add in the fact that their interest is exempt from federal income tax, state income tax for in-state residents, and sometimes the alternative minimum tax, and it's small wonder that investors have been devouring them since the start of 2009.

There were eight new muni bond ETFs that began trading in the first two months of 2010, according to Investment Company Institute data, more than any other ETF category, making a total of 28 funds. Muni ETF assets have surged 153% since January, 2009.

Muni bond ETFs offer investors the same benefits of muni bond mutual funds--broad diversification, monthly distributions, specific portfolios for high-tax states like New York and California, and a choice of duration at a lower cost. Most muni bond ETFs charge about 0.3% in annual fees, while the average muni bond mutual fund charges about 1%.

Six ETF sponsors--BlackRock's iShares, State Street's SPDRs, Van Eck's Market Vectors, Allianz's PIMCO, Grail Advisors and Invesco's PowerShares--offer muni bond ETFs. The three funds offered by PIMCO and the Grail Fund are actively managed, while the other funds track an index. PowerShares, iShares and State Street offer funds that invest in muni bonds from all over the United States, known as "national" funds, as well as funds designed specifically for California and New York residents, which have high state income-tax rates. Of these funds, iShares S&P National AMT-Free Municipal Bond Fund (MUB) is by far the largest, with about $1.8 billion in assets. The fund's last dividend payment was equivalent to a 3.75% annual yield.

Market Vectors offers long-, short- and intermediate-term funds, while SPDR and iShares each have short-term muni bond ETFs. Short-term funds currently yield about 1%, while the Market Vectors intermediate-term fund (ITM) currently yields about 3.5% and the long-term fund (MLN) about 4.6%. For those who want a more specific duration, iShares has six different "fixed end date" muni bond ETFs with maturities every year from 2012 to 2017. Those funds hold only securities that mature in the specified year and they liquidate when the last holding matures.

There are several specialty muni bond ETFs as well. Investors who can tolerate an extra degree of risk might consider the Market Vectors High Yield Municipal ETF (HYD), which invests in the highest yielding muni bonds available. This $156 million fund includes many investment grade issues, with the average credit quality of its holdings just below investment grade at BBB-. About 22% of its holdings were issued by the health and hospitals industry, and about one quarter comes from California or New York. Some 40% of its holdings have maturities of 20 years or longer.

On the other end of the risk spectrum, the Market Vectors Pre-Refunded Municipal Index ETF (PRB) invests in the safest muni bonds available: bonds that have been refinanced but that have not yet reached maturity. Often, municipal bond issuers will issue new bonds to take advantage of a drop in interest rates, and set the proceeds aside in an escrow account holding Treasury debt to pay off the old bond. These "pre-refunded" bonds thus become almost as safe as Treasury debt, yet they still have the tax advantages and higher coupon of municipal debt. This $37 million fund currently yields about 1.5%.

With interest rates likely to rise in the future from their current record lows, ETFs such as the State Street's SPDR Nuveen S&P VRDO Municipal Bond ETF (VRD) and PowerShares VRDO Tax Free Weekly Portfolio (PVI) may become more popular. VRDO stands for "variable rate demand obligation," a type of long-term bond issued by municipalities that pays a floating rate of interest, usually reset weekly. While these funds currently offer yields of less than 1%, which will change if short-term rates move higher. PVI is the older and larger of the two, with $851 million in assets, while VRD has just $15 million in assets.

Build America Bonds
A little known species inhabiting the municipal bond market is the taxable municipal bond, which municipal issuers must turn to when the use of their proceeds doesn't meet federal standards for tax-exempt financing. As part of the 2009 stimulus package, the Treasury created Build America Bonds (BABs), in which the government would reimburse states for 35% of their borrowing cost for projects that would otherwise not qualify for tax exempt financing. About $27 billion in Build America Bonds have been issued to fund education, transportation and other infrastructure projects. The PowerShares Build America Bond Portfolio (BAB) started trading in November, 2009 and has about $250 million in assets. Its last distribution had an annual yield of about 6.22%. For more about BABs please see "How Are Build America Bonds Working?"

The mechanics of a muni bond ETF are somewhat different from most other ETFs. For the majority of equity ETFs and many fixed income ETFs, trading companies known as Authorized Participants act to keep the share price in line with the value of the fund's underlying assets through the create/redeem feature, in which they can either deliver a basket of the underlying securities in exchange for new shares, or deliver shares in exchange for the underlying securities. Because there is almost no secondary market for any specific municipal bond, muni ETFs must use a different process.

Each ETF sponsor has approached the problem differently. State Street allows Authorized Participants to pay cash for new shares for its muni ETFs, though it will deliver securities to fund redemptions. Muni ETFs run by iShares create a list of securities that they will accept for delivery in exchange for new shares, while MarketVectors is trying to patent the process it developed to state only the criteria of the bonds it will accept in exchange for new shares. In this way, passively managed muni ETF funds start to resemble actively managed funds.

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S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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