Muni Bonds Gain Appeal with ETFs

Municipal bond exchange-traded funds are attracting a lot of attention. But do they make sense for your portfolio?

by David Bogoslaw

A new way to own municipal bonds at a low cost has hit the market with the launch of a handful of new exchange-traded funds (ETF) that will track municipal bond indexes. The main advantage for cost-conscious retail investors is they will have access to an entire universe of municipal bonds at an affordable price.

Investors have been flocking to ETFs of all stripes in recent years not only for their comparatively low management fees, but to gain more tax efficiency and the ability to trade them as often as they like.

The municipal bond ETFs "are a welcomed addition because they will bring transparency to a market that is notoriously opaque," wrote Rudy Aguilera, a founding principal of Helios and a registered investment adviser in Orlando, Fla., in a Sept. 10 blog post. He cited the comparatively narrow bid-ask spread for ETFs, vs. the huge differentials on order executions in the municipal bond market, and thinks individual investors would benefit from the new vehicles.

Flexible Portfolios

While the new ETFs represent the wide range of muni bonds available, it wouldn't be cost-effective for a portfolio manager to exactly replicate the index. Instead, the ETFs hold a representative sampling of the bonds in the index, which can be astonishingly small.

Take the SPDR Lehman Municipal Bond ETF (TFI) that State Street Global Advisors unveiled on Sept. 13. It is meant to correspond to the price and yield performance of the Lehman Brothers (LEH) Municipal Managed Money Index, which is comprised of more than 22,000 issues in the most liquid part of the muni bond market. Yet at launch, the ETF included just 22 issues, or 0.001% of issues in the index.

The first muni bond ETF, the iShares S&P National Municipal Bond Fund (MUB), which Barclays Global Investors launched on Sept. 10, includes 30 issues, or about one-hundredth of the 3,069 issues in the brand new Standard & Poor's National Municipal Bond Index, which the ETF tracks. (Like BusinessWeek.com, S&P is a unit of The McGraw-Hill Companies (MHP).)

As investors put money into these funds, the portfolio managers will have more flexibility to boost the number of bonds as they adjust the holdings on a monthly basis. The SPDR Lehman Municipal Bond ETF could include 100 or more issues at some time in the future, says Anthony Rochte, senior managing director at State Street Global Advisors.

The portfolio manager chooses the bonds he wants to hold. For example, the SPDR Lehman ETF won't include any hospital-, housing-, airline-, or tobacco-based bonds, Rochte said.

The Liquidity Factor

Other muni ETFs are expected to debut soon: Six from Van Eck Securities, which will track various Lehman Brothers indexes, and another four from PowerShares Capital Management, which will follow Merrill Lynch (MER) indexes.

Unlike most individual muni bonds, which tend to sit untouched in people's bank vaults and are used to avoid federal and state taxes, the main purpose of bundling them in an ETF is to create something that's tradable, for which liquidity is a key factor. To be included in the SPDR Lehman ETF, bonds must have an outstanding par value of at least $7 million or be part of a transaction on issuance of at least $75 million, Rochte said. The iShares S&P National Municipal Bond Fund requires a minimum par value of $50 million.