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A Tax-Smart, Income-Rich ETF

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As the year draws to a close, many investors think of the taxes they've accumulated on their stock dividends. But one group of ETFs lets investors relax, providing tax-exempt income all year round.

Municipal bond ETFs are one of the newest categories of exchange-traded funds, with four ETF sponsors offering national muni ETFs. The SPDR Lehman Municipal Bond Fund (NYSE: TFI  )  has generated the best performance of the lot to date. It's worth considering if you're looking to reduce your tax burden, and you can accept a modest return on your investment.

Meet the muni master
The SPDR Muni fund tracks the National Municipal Bond Index, which is made up of long-term U.S. tax-exempt bonds. That means you won't find any corporate bond surprises from issuers like AIG (NYSE: AIG  ) and Citigroup (NYSE: C  ) in this fund.

You will find bonds from municipalities as geographically diverse as Birmingham, Ala. and Honolulu, Hawaii. New York and California are the heaviest weightings, accounting for a combined 30% of all holdings. The fund is focused on higher-quality issuers, with more than 97% of its holdings rated A or higher. SPDR Muni uses a sampling technique to pick from the many bonds in the index.

Fast fund facts

  • One-Year Return: (2.2%)
  • Net Expense Ratio: 0.20%
  • Assets: $300 million

Prospects and risks
The bond insurance industry suffered severe turbulence throughout 2008, as the financial strength of Ambac Financial (NYSE: ABK) and MBIA (NYSE: MBI  ) grew increasingly questionable. That uncertainty has fed into the municipal bond market, causing yields to rise and prices to fall.

Because the SPDR Muni fund does not completely replicate its index, high market volatility makes it more likely that the fund will have difficulty tracking its index. Another risk in fast-changing markets is the potential that illiquid or erratic price movements will cause the fund's price to differ from the value of its assets. As the economy ratchets downward, municipalities face ever-tougher financial choices, and there is a stronger likelihood that some municipal bonds will default.

The economic contraction is likely to stress many municipal issuers to the limit. In addition, those who access the credit markets now for more capital are likely to face higher borrowing costs. Those higher costs for issuers translate into potentially higher returns for new investors, however, and that can compensate for the higher risks they are likely to face.

Portfolio fit?
Unlike an investor who has a position in one or a handful of muni bonds -- and who usually ends up paying high transaction costs -- a municipal bond ETF is a relatively inexpensive way to purchase muni bonds and spread the risk of any single issue defaulting. Muni bond ETFs are not an investment for those seeking high returns, but they are one way to easily diversify a portion of your fixed-income allocation and reduce your income-tax obligations.

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Fool contributor Zoe Van Schyndel now lives in the Seattle area, where she enjoys the coffee and natural wonders. She does not own any of the funds or securities mentioned in this article. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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