In the past, if you wanted to buy municipal bonds, you had to buy individual bond issues in the over-the-counter market. Then, in the 1970s and 1980s, mutual funds that invested in municipal bonds came onto the scene. Investors now have another option for investing in the municipal bond market -- exchange-traded funds. And odds are good that many more of these muni bond ETFs will be available to investors in the coming months.

Tax-free income
Municipal bonds are bonds issued by state, local, and other governmental entities to raise money for public works projects such as schools, bridges, and highways. The interest income generated by muni bonds is exempt from federal income tax, and in some cases, from state and local income taxes as well. As a result, muni bonds are especially popular with wealthy investors in higher tax brackets, who would get the greatest relief by avoiding these taxes.

Like any bond, municipal bonds are priced on the basis of credit quality, maturity, liquidity, and yield. While muni bonds are thought to be fairly safe investments, they are not entirely risk-free. For example, municipal bondholders face credit risk (the risk that the issuer will be unable to pay its obligations) and interest rate risk (the risk that rates will rise in the future, making their muni bond worth less in the marketplace). Despite these risks, muni bonds can be an excellent income-producing tool for your portfolio. The market for these bonds has grown to more than $1.7 trillion dollars, with more than 5.1 million households owning muni bonds in some form.

New options
And now exchange-traded funds offer yet another avenue for easy muni bond investing. On Sept. 10, Barclays Global Investors introduced its iShares S&P National Municipal Bond Fund (AMEX:MUB), which tracks a muni bond index maintained by Standard & Poor's. The expense ratio on this ETF is 0.25%. Right on Barclays' tail, State Street rolled out its new SPDR Lehman Municipal Bond ETF (AMEX:TFI) on Sept. 13. This fund, with a 0.20% expense ratio, tracks the Lehman Brothers Municipal Managed Money Index.

Both of these ETFs will use sampling techniques to replicate their respective indices. For example, the Barclays ETF currently has 39 holdings, whereas the S&P index it tracks has more than 3,000. Likewise, the State Street version has 28 holdings right now, while the Lehman Muni Index follows more than 22,000 muni bond holdings. While sampling indices is common for bond funds, this means that these particular funds could be more prone to tracking error. Investors who buy these ETFs hoping to get exactly the market rate of return should be aware that their individual return may slightly deviate from the market at times.

New and improved
So muni bond investors should run right out and buy some of these new ETFs, right? Well, not necessarily. While ETFs do offer an inexpensive entry into many market segments, it can be hard for investors to resist the lure of these funds' easy trading ability. Because these funds can be traded throughout the day like stocks, some folks use this as an excuse to try to time the market and make multiple trades in a very short time period. This is not a reliable investing strategy, so if that is what you intend to do, stick with your traditional muni bond fund or individual muni bond issues.

But if you are simply looking for a cheap way to get into the municipal bond market, some of the new ETFs might be right for you. Just remember that it is not entirely clear how much demand there will be for these types of funds. As a result, liquidity may be an issue, and spreads for these funds may be bigger than with more widely traded ETFs. But if you are a long-term, buy-and-hold municipal bond investor, these new funds may be just what you are looking for.

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