Touring The Muni Bond ETF Universe

Innovation has become a common occurrence in the ETF industry in recent years, transforming the product lineup from a collection of blunt instruments into an arsenal of more than 1,400 investing tools. Among those products are a growing number of precise, targeted tools that allow investors an unprecedented level of granularity when building a portfolio. This is certainly the case in the muni bond ETF space, where more than a dozen ETFs slice and dice the market to deliver unique blends of risk and return potential [see our Ready To Retire ETFdb Portfolio].

By far the most popular muni bond ETF is the iShares S&P National Municipal Bond Fund (MUB), which has nearly $3 billion in assets and casts a wide net across this corner of the fixed income market. But for investors looking to utilize more precise tools to access muni bonds, there are a number of other options out there as well:�

Short Term Munis

For investors looking to access muni bonds but concerned about interest rate risk, focusing on shorter duration securities is the obvious move. The Market Vectors Short Municipal Bond Index ETF (SMB) offers an efficient way to access these types of securities; this fund has an average modified duration of only about three years. Of course, avoiding interest rate risk comes at the expense of expected yield; SMB has a 12-month yield of only about 1.84% [see also Bond ETFs For Every Objective].

Long Term Munis

At the opposite end of the maturity spectrum is the Market Vectors Long Municipal Bond Index ETF (MLN), which concentrates its portfolio on longer-dated securities. MLN’s average modified duration is closer to 14 years, meaning that this fund will be much more sensitive to interest rate changes. MLN also comes with a much more attractive yield profile; this ETF has a 12-month yield of about 4.3%.

Build America Bonds

Build America Bonds are an interesting remnant of the American Reinvestment and Recovery Act of 2009; though the program that facilitated the issue of these bonds was short lived, ETFs holding these securities figure to be around for quite a while. Though generally issued by state and local governments, Build America Bonds are different from traditional munis in that interest earned is not tax deductible. Rather, the Treasury effectively subsidizes a portion of the interest payments made by the issuers, meaning that these bonds were able to be issued with attractive yields that wouldn’t place a huge burden on the issuers [see also Five ETFs George Washington Probably Would Have Liked].

Build America Bond ETFs represent a way to capture a meaningful yield without concentrating risk in any municipality:

• PowerShares Build America Bond Fund (BAB)
• SPDR Nuveen Barclays Capital Build America Bond ETF (BABS)
• PIMCO Build America Bond Strategy Fund (BABZ)

High Yield Munis

Though most muni bonds have relatively strong credit ratings due to the ability of issuers to raise funds through tax increases, there are segments of this asset class that feature elevated credit risk. Along with that additional risk, of course, comes higher yields.�High yield munis often include debt issued by hospitals in connection with a local municipality, as well as industrial revenue bonds. Effective yields on ETFs targeting these muni bonds can approach 9% for those in the top tax bracket:

• Market Vectors High Yield Municipal Index ETF (HYD)
• SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB)

Target Date Munis

Most muni bond ETFs are designed to operate indefinitely, using any proceeds from maturities to purchase longer-dated funds. But iShares offers a lineup of muni bond ETFs that deliver a cash flow experience similar to individual bonds. These funds concentrate on muni bonds maturing in a certain year, meaning that the interest rate risk component gradually declines as the maturity date approaches. And as the target date approaches and the underlying bonds mature, these ETFs will gradually convert to cash that will ultimately be distributed to shareholders [see also Wide World Of Muni Bond ETFs]:

• 2012 S&P AMT-Free Municipal Series (MUAA)
• 2013 S&P AMT-Free Municipal Series (MUAB)
• 2014 S&P AMT-Free Municipal Series (MUAC)
• 2015 S&P AMT-Free Municipal Series (MUAD)
• 2016 S&P AMT-Free Municipal Series (MUAE)
• 2017 S&P AMT-Free Municipal Series (MUAF)

Pre-Refunded Munis

The Market Vectors Pre-Refunded Municipal Index ETF (PRB) is one of the more unique bond ETFs on the market. This fund holds municipal bonds that are pre-refunded and escrowed-to-maturity–meaning that they are backed by obligations issued or guaranteed by the U.S. government.

When an issuer of a municipal bond, such as a state or local government, has enough cash to satisfy an obligation but isn’t able to call a series of bonds, they may elect to pre-refund those securities. That generally involves purchasing Treasuries and placing them in an escrow account, and then using the interest proceeds from the Treasuries to meet their obligations on the municipal debt. The result is a security that is essentially safe as Treasuries and tax-free. Once the municipal bonds come due, the issuer can sell the Treasuries and pay off investors with the proceeds.

Not surprisingly, PRB features relatively low yields; the 30 day SEC yield is only about 40 basis points.

Actively Managed Munis

For investors who would prefer to have an experienced manager guiding their positions in munis, there are a couple of actively managed ETFs out there that combine the benefits of the exchange-traded structure with municipal bond exposure:

• Columbia Intermediate Municipal Bond Strategy Fund (GMMB)
• PIMCO Intermediate Municipal Bond Strategy Fund (MUNI)

Variable Rate Demand Obligations (VRDOs)

VRDOs are an interesting type of security that offers very little in the way of risk. VRDOs are floating rate bonds that deliver tax-exempt income to investors. If investors want to redeem VRDOs, they can do so by selling back to investment dealers at par plus accrued interest. Most VRDOs include some source of liquidity support, such as a letter of credit of standby bond purchase agreement provided by a large financial institution. As such, VRDOs feature both very low interest rate risk and minimal credit risk.

There are a couple of ETFs that offer exposure to VRDOs:

• PowerShares VRDO Tax-Free Weekly Portfolio (PVI)
• SPDR S&P VRDO Municipal Bond ETF (VRD)