Muni Bonds Gain Appeal with ETFs

Municipal bond exchange-traded funds are attracting a lot of attention. But do they make sense for your portfolio?

A new way to own municipal bonds at a low cost has hit the market with the launch of a handful of new exchange-traded funds (ETF) that will track municipal bond indexes. The main advantage for cost-conscious retail investors is they will have access to an entire universe of municipal bonds at an affordable price.

Investors have been flocking to ETFs of all stripes in recent years not only for their comparatively low management fees, but to gain more tax efficiency and the ability to trade them as often as they like.

The municipal bond ETFs "are a welcomed addition because they will bring transparency to a market that is notoriously opaque," wrote Rudy Aguilera, a founding principal of Helios and a registered investment adviser in Orlando, Fla., in a Sept. 10 blog post. He cited the comparatively narrow bid-ask spread for ETFs, vs. the huge differentials on order executions in the municipal bond market, and thinks individual investors would benefit from the new vehicles.

Flexible Portfolios

While the new ETFs represent the wide range of muni bonds available, it wouldn't be cost-effective for a portfolio manager to exactly replicate the index. Instead, the ETFs hold a representative sampling of the bonds in the index, which can be astonishingly small.

Take the SPDR Lehman Municipal Bond ETF (TFI) that State Street Global Advisors unveiled on Sept. 13. It is meant to correspond to the price and yield performance of the Lehman Brothers (LEH) Municipal Managed Money Index, which is comprised of more than 22,000 issues in the most liquid part of the muni bond market. Yet at launch, the ETF included just 22 issues, or 0.001% of issues in the index.

The first muni bond ETF, the iShares S&P National Municipal Bond Fund (MUB), which Barclays Global Investors launched on Sept. 10, includes 30 issues, or about one-hundredth of the 3,069 issues in the brand new Standard & Poor's National Municipal Bond Index, which the ETF tracks. (Like, S&P is a unit of The McGraw-Hill Companies (MHP).)

As investors put money into these funds, the portfolio managers will have more flexibility to boost the number of bonds as they adjust the holdings on a monthly basis. The SPDR Lehman Municipal Bond ETF could include 100 or more issues at some time in the future, says Anthony Rochte, senior managing director at State Street Global Advisors.

The portfolio manager chooses the bonds he wants to hold. For example, the SPDR Lehman ETF won't include any hospital-, housing-, airline-, or tobacco-based bonds, Rochte said.

The Liquidity Factor

Other muni ETFs are expected to debut soon: Six from Van Eck Securities, which will track various Lehman Brothers indexes, and another four from PowerShares Capital Management, which will follow Merrill Lynch (MER) indexes.

Unlike most individual muni bonds, which tend to sit untouched in people's bank vaults and are used to avoid federal and state taxes, the main purpose of bundling them in an ETF is to create something that's tradable, for which liquidity is a key factor. To be included in the SPDR Lehman ETF, bonds must have an outstanding par value of at least $7 million or be part of a transaction on issuance of at least $75 million, Rochte said. The iShares S&P National Municipal Bond Fund requires a minimum par value of $50 million.

Credit quality is also a concern when it comes to muni bonds. Bonds are usually included in investors' portfolios to help diversify risk away from the more volatile returns on equity holdings. But municipal bonds have more risk associated with them than U.S. Treasury bonds, chiefly because the tax base backing them is much smaller.

The average credit quality of the bonds in the SPDR Lehman index must be AA1/AAA, and none of them are currently subject to the Alternative Minimum Tax (AMT), which applies to municipal bonds whose proceeds are used in part to fund private-interest projects. The S&P index has an average credit quality of AAA/AA, and to qualify, the bonds in the index must have a rating of at least BBB- by S&P, Baa3 by Moody's Investors Service (MCO), or BBB- by Fitch Ratings.

Piece of the Pie

These ETFs also offer the low management fees that ETF investors enjoy. "The real draw [of the SPDR ETF] is the ability for investors to gain exposure to muni bonds at 20 basis points, vs. the Morningstar (MORN) average of 91 basis points" for municipal bond funds, Rochte said.

The annual expense ratio for the iShares fund is 25 basis points, and there is no minimum investment required, says Christine Hudacko, a principal at Barclays Global Investors.

Another key feature is investors will be able to own a piece of a variety of bonds, where in the past they may not have been able to afford even one individual muni, which are often not available in blocks worth less than $20,000, as brokers prefer to sell them in bigger bulks, said Rochte.

Risky Business?

Jeff Broadhurst, president of Broadhurst Financial Advisors in Philadelphia, says he's not a fan of municipal bonds and prefers to use high-quality, short-duration bonds when building his clients' portfolios. Even muni bonds that aren't subject to the AMT need to yield more than 3.25% to beat a Treasury bond, and there aren't many with yields that high.

"I'd want them to yield more because there's more risk in those munis than in federal government [issues]," Broadhurst says, referring to the smaller tax base than the more than 300 million people whose taxes are backing Treasury notes.

Another risk in munis is the potential for credit downgrades to below investment grade, as bonds issued by Detroit and New Orleans have experienced in recent memory, he adds.

"I don't know [the ETFs'] exact policy of getting in and out of securities, but if a bond starts to go south, you're not getting out at par. You're getting out at 80 or 70 [cents] on the dollar," Broadhurst says.

The iShares fund managers will be monitoring the credit quality of individual bonds within the index on a daily basis, said Hudacko at Barclays. If they see something that's no longer appropriate for the portfolio, they can take it out without waiting for the index to remove it first.

Although the new muni ETFs are the flavor of the moment, there are already low-cost ways for investors to get municipal bond exposure, even some that stretch back 30 years. The Vanguard Group offers six tax-exempt funds with minimum expense ratios between 14 and 17 basis points, lower than State Street's new ETF, says John Woerth, a principal at the Vanguard Group, located outside Philadelphia. Each fund is no-load and requires a minimum initial investment of $3,000.

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