First tax-free bond ETF hits the market

Posted by: Aaron Pressman on September 10, 2007

Barclays today opened the first exchange-traded fund that holds municipal bonds and pays tax-exempt interest. But the big appeal here isn’t the fact that here’s now a minute-to-minute trading price for municipal bond funds — it’s that there’s a cheap, index fund owning munis at all. As far as I have seen, all muni bond mutual funds, which typically charge fees three or four times higher than the new Barclays ETF, are actively managed.

Barclays beat a handful of leading ETF vendors who have been racing to bring various kinds of muni ETFs to market. The Barclays fund, called the iShares S&P National Municipal Bond Fund, trades under the symbol MUB. It tracks a new S&P index of investment grade muni issues with at least $50 million on the market. Barclay’s fee of 0.25% of the fund’s assets is far below the typical fee charged by actively managed muni funds.

Investment adviser Rudy Aguilera, writing on the IndexUniverse blog, says the Barclays muni fund and others expected to follow will investors gain access to the tax-exempt market without having to worry about the notoriously shadowy world of muni bonds. Because there are so many different bond issues and they are traded over-the-counter by brokers, it’s very difficult for an individual investor to know whether they’re getting a fair price. That shows up in the bid/ask spread, or the difference between what a broker will pay for your muni bond versus how much he or she will charge to sell you the very same bond. Aguilera writes:

“Just go to investinginbonds.com and look through the order executions of the municipal market and you will see spreads that look as wide as an eight-lane interstate compared to the jogging trails that are ETF spreads. I sincerely believe that the individual investor will be the real beneficiary of this latest financial innovation.”

Barclays and others have already filed with the Securities and Exchange Commission to create a variety of twists on the first muni ETF. Expect several funds investing only in California or New York bonds as well as funds slicing the market by maturity. The state-specific funds set up an interesting arbitrage play as the Supreme Court accepted a case for its next term considering whether states that grant tax-exempt status to interest paid on their own bonds can legally collect taxes on interest from bonds issued in other states. If the court says no, expect a huge amount of selling to depress the prices of states with the highest income taxes, like New York and California, as local taxpayers are freed to own any state’s bonds and get the same advantages. If that seems likely, a play buying the new iShares fund and shorting one of the upcoming New or California muni funds may be in order.

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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