Odds are, if there's an investment out there, there's an exchange-traded fund (ETF) tracking it. Although ETFs initially focused on stocks, bond ETFs have become more popular recently. Earlier this month, the first municipal bond ETFs hit the market.
These new funds are attractive in part because interest on municipal bonds is exempt from federal income tax. With low expense ratios, ETFs are an interesting way to invest in muni bonds.
First out of the gate
The iShares S&P National Municipal Bond ETF (AMEX:MUB) came to market on Sept. 7. The fund tracks the S&P National Municipal Bond Index, which includes 3,069 state and local government bonds with investment-grade ratings.
The fund uses representative sampling to replicate the index and can also invest up to 20% of its assets in futures, options, swap contracts, or cash. Its expense ratio is 0.25%. The fund has an average maturity of about 11 years, making it a long-term bond fund.
A close second
Three days after the iShares fund came to market, the SPDR Lehman Municipal Bond ETF (AMEX:TFI) started trading. This fund tracks the performance of the Lehman Brothers Municipal Managed Money Index, which includes more than 22,000 issues. This index has a higher credit-rating threshold, requiring a rating of AA- or higher from at least two ratings agencies.
With such a large universe, the SPDR Lehman Municipal Bond ETF does not attempt to invest in every bond; it uses a sampling approach. Like the iShares fund, the SPDR fund can invest 20% of its assets in derivatives and other securities. Its expense ratio is 0.20%, and the portfolio is invested in securities that have maturities of 10 to 20 years, with an average life of about 12 years.
Risks
Municipal bonds might be considered a low-risk investment, but there have been some notable defaults, such as Orange County, California, in 1994. The muni marketplace has a number of risks and can be affected by tax, legislative, or political changes, along with local business and economic conditions.
Municipal bonds vary in their credit risk, or the risk that an issuer is unable or unwilling to make timely interest or principal payments. Holding a portfolio of highly rated bonds is one way to try to avoid this risk. Also, like other bonds, municipals face interest-rate risk -- if rates rise, the value of the bonds in the portfolio would fall.
Competition coming
Investors in the highest tax brackets are the ones who are most likely to benefit from these funds. State-specific muni funds are also in the works, and they will have the additional benefit of being exempt from state tax for residents of particular states.
In addition, you can expect new players in the muni bond ETF market. Van Eck and PowerShares are both seeking to create such funds, and Barclays (NYSE:BCS) and State Street (NYSE:STT) have additional funds awaiting approval from the Securities and Exchange Commission. The new funds include several New York and California munis; residents of those populous states can use them to reduce their tax burdens.
Variety: the spice of investing
Muni ETFs give investors an easier way to get returns from a slice of the market that can be expensive to get access to. With relatively low fees and high-quality portfolios, either the iShares or the SPDR muni fund could be a good addition to a diversified portfolio.
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