ETFs That Cut The Cost Of Munis

New products get you in without the high expense ratios of municipal bonds

Municipal bonds Tend to sit untouched in investment portfolios earning tax-free interest until they mature or are called. So it seems a bit counterintuitive to bundle bonds that rarely trade in a vehicle designed for trading. Still, the latest batch of exchange traded funds (ETFs) to hit Wall Street provides a convenient way to invest in tax-exempts.

Two muni-bond ETFs were launched in the past month, and 10 more are on the way: Six from Van Eck Securities (INIVX ) will track various Lehman Brothers (LEH ) indexes, and four from PowerShares Capital Management will follow Merrill Lynch (MER ) benchmarks. They're helping to create a liquid market for a lot of illiquid assets, says Kirk Kinder, a certified financial planner at Picket Fence Financial in Bel Air, Md.

The ETFs address the most notorious shortcoming of muni bonds: pricing. In the muni-bond market, there can be a huge gap—$20 or $30 per $1,000 bond—between the bid and the ask price, or what dealers pay sellers and charge buyers. In contrast, the bid-ask spread for ETFs is a couple of pennies per share, the equivalent of $1 or $1.50 per $1,000. In addition, because ETF managers trade in volume, they can buy and sell at better prices.

It's not cost-effective to replicate indexes exactly, so the muni ETFs hold just a fraction of the bonds in their bogeys. The SPDR Lehman Municipal Bond ETF (TFI) that State Street Global Advisors (STT ) rolled out on Sept. 13 is meant to track the Lehman Brothers Municipal Managed Money Index, an intermediate-term benchmark with an average maturity of 10 years and a current yield of 4.6%. At launch, the ETF included only 22 of the more than 22,000 issues in that index.

Similarly, there are just 30 bonds in the iShares S&P National Municipal Bond Fund (MUB), which Barclays Global Investors introduced on Sept. 10, vs. 3,069 in the new Standard & Poor's National Municipal Bond Index. It has a 12-year average maturity and a 4% yield. (Like BusinessWeek, S&P is a unit of The McGraw-Hill Companies (MHP ).) As investors put money into these funds, portfolio managers will have more flexibility to increase the number of bonds.

Credit quality is also a concern with munis. With the iShares fund, two-thirds of the bonds are in the highest ratings category. The bonds in the SPDR Lehman index have an average rating that falls within the top two tiers of credit quality. Plus, none of the SPDR fund's bonds are currently subject to the alternative minimum tax (AMT), which applies to munis whose proceeds go in part to fund private-interest projects. That's an important feature since every year more investors become subject to the AMT.


These ETFs also offer low management fees. "The real draw [of the SPDRETF] is the ability of investors to gain exposure to muni bonds at a 0.20% expense ratio, vs. the Morningstar (MORN ) average of 0.91% for municipal-bond mutual funds," says Anthony Rochte, a senior managing director at State Street Global Advisors. The annual expense ratio for the iShares fund is 0.25%.

The new muni ETFs are the flavor of the moment, but there are already low-cost ways for investors to get municipal-bond exposure. Vanguard Group offers six tax-exempt funds with expense ratios of 0.14% to 0.17% basis points—even lower than State Street's ETF, says John Woerth, a Vanguard spokesman. Each fund is no-load and requires a minimum initial investment of $3,000.

Although he's excited about the prospects of muni ETFs adding liquidity to the tax-exempt market, Frank Armstrong, president of Investor Solutions in Coconut Grove, Fla., says he'll watch these ETFs for a while before investing. "You want to make sure they're really tracking the underlying indexes."

By David Bogoslaw

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