A Smorgasbord of Muni Bond ETFs

As investors have become more comfortable with the idea of achieving fixed income exposure through the exchange-traded structure, bond ETF assets have skyrocketed and the number of funds has increased rapidly. For those in higher tax brackets, municipal bonds have always been a popular option, as the tax-exempt feature of the interest payment boosts the tax-equivalent yield realized. And many in these higher tax brackets have embraced ETFs as the most efficient means of achieving exposure: the S&P National AMT-Free Municipal Bond Fund (MUB) has more than $2 billion in assets. But while MUB is the most popular ETF offering exposure to the muni bond market, it’s hardly the only option available. Below, we profile more targeted muni bond ETF options covering various durations, credit qualities, and geographies:

High Yield Muni Bond ETF

For investors looking to capture the potential tax advantages of muni bonds without sacrificing pre-tax yield, the Market Vectors High Yield Municipal Bond ETF (HYD) is an intriguing option. This fund is linked to the Barclays Capital Municipal Custom High Yield Composite Index, a benchmark that has a 25% weighting in investment grade BBB bonds and 75% weightings in non-investment grade bonds. The focus on lower quality munis translates into a material increase in yield; HYD’s 30-day SEC yield recently stood around 5.6%, which translates into a tax equivalent yield of 8.6% for those in the 35% tax bracket. By comparison, MUB has a tax equivalent 30-day SEC yield in the neighborhood of 4.2%.

Target Duration Muni Bond ETFs

While the most popular municipal bond ETFs include securities of all durations, there are a number of funds that allow investors to zero in on a specific portion of the maturity spectrum. Options for targeting municipal bonds corresponding to a particular duration include:

• Short-Term: SPDR Barclays Capital Short Term Municipal Bond ETF (SHM), Market Vectors Short Term Municipal Bond ETF (SMB), PIMCO Short-Term Municipal Bond ETF (SMMU).
• Intermediate-Term: Grail McDonnell Intermediate Municipal Bond ETF (GMMB), Market Vectors Intermediate Term Municipal Bond ETF (ITM), PIMCO Intermediate Municipal Bond ETF (MUNI)
• Long-Term: Market Vectors Long Term Municipal Bond ETF (MLN)

The impact of a fund’s effective duration on bottom line return can be significant; the gap in year-to-date returns between MLN and SMB is close to 300 basis points.

iShares takes the ability to target durations to a new level, offering a suite of ETFs focusing on municipal bonds maturing in a specific year. Unlike most bond funds that reshuffle holdings as effective durations change, these funds hold muni bonds maturing in a certain year until maturity, meaning that each fund will gradually shift to cash as it approaches its maturity date. There are currently six target date muni bond ETFs, ranging from 2012 (MUAA) to 2017 (MUAF).

Build America Bond ETFs

One of the hottest corners of the ETF industry focuses on securities that only came into existence last year. As a part of the American Recovery and Reinvestment Act of 2009, the Build America Bond program was introduced as a way to provide funding to state and local governments at lower borrowing costs than they would be able to achieve on their own. Build America Bonds are very different from most municipal bonds in one key way; they are taxable securities issued by local governments to give them access to conventional corporate debt markets. The Treasury Department makes a direct payment to the issuing municipality in an amount equal to 35% of the interest payment on Build America Bonds, thereby allowing issuers to offer debt that has an attractive coupon from an investor perspective but a reduced interest burden from the issuer perspective.

So it’s not surprising that many investors have embraced Build America Bonds as a means of enhancing the current return portion of their portfolios. Currently, there are three ETFs offering exposure to this asset class:

• PowerShares Build America Bond Portfolio (BAB)
• SPDR Nuveen Build America Bond ETF (BABS)
• PIMCO Build America Bond Strategy ETF (BABZ)

One interesting note on these securities: the Build America Bond program is due to expire at the end of this year, but is widely expected to be extended by Congress. If for some reason that renewal stalls, the pool of Build America Bonds would shrink gradually until all have been repaid.

Actively-Managed Muni Bond ETFs

For investors more comfortable with an active manager overseeing their exposure to municipal bonds, there are multiple actively-managed ETFs within this asset class. Two of the PIMCO ETFs highlighted above, MUNI and SMMU, are actively-managed, as is Grail’s GMMB.

Some investors expect actively-managed ETFs to come with a significantly higher price tag than their passively-indexed counterparts, but that isn’t really the case in the municipal bond space. All three of the actively-managed muni bond ETFs charge expense ratios of 0.35%, only slightly higher than the 0.29% average for the National Munis ETFdb Category.

Pre-Refunded Muni Bond ETF

The Market Vectors Pre-Refunded Municipal Index ETF (PRB) offers a unique twist on traditional muni bond funds. This product tracks the Barclays Capital Municipal Pre-Refunded Treasury-Escrowed Index, a benchmark comprised of securities secured by an escrow or trust account containing obligations directly issued or unconditionally guaranteed by the U.S. government. “Pre-re’s” are created when municipalities refinance existing debt, often to take advantage of lower interest rates. To accomplish this, “refunding” bonds are issued, and the proceeds are used to buy securities that are placed in escrow and dedicated to paying the interest and principal on the original issue.

That makes pre-refunded munis the highest credit quality available in the municipal bond market, especially those backed by U.S. Treasuries and State and Local Government Series Bonds. As such, these securities will generally offer a slightly lower yield than otherwise comparable securities; the SEC 30-day yield on PRB is only about 0.70%, or 1.0% on a tax-equivalent basis.

Insured Muni Bond ETF

Some municipal bonds receive credit enhancement in the form of insurance policies against default. When certain munis are issued, an insurance policy guarantees bond holders against losses resulting from a default by the issuer for the full term of the issue. In most cases, this insurance results in the related security receiving a AAA rating, making it one of the highest credit municipal bonds available. As its name suggests, the PowerShares Insured National Municipal Bond Portfolio (PZA) tracks an index comprised of insured municipal bonds. Again, this boost in creditworthiness often comes at the expense of yield; PZA will generally exhibit a current yield somewhere between those of MUB and PRB.

State-Specific Muni Bond ETFs

For investors looking to gain access to municipal bonds issued by entities from a particular state, there are a handful of options available. Currently, there are three ETFs in both the New York Munis and California Munis ETFdb Category, with aggregate assets of more than $500 million in these six funds. In addition to being two of the largest states in the country, California and New York also face two of the biggest deficits and have been on unstable fiscal footing for the last several years. As such, bonds issued by municipalities in these states will generally offer both additional risk and additional potential return relative to more broad-based funds.

While ETFs focusing on municipal bonds issued by a specific state may seem overly-precise, the granularity available through ETFs pales in comparison to the options accessible through mutual funds. There are currently hundreds of mutual funds that focus on municipal bonds tied to dozens of individual states, including Connecticut, Ohio, Kentucky, and many more.

Disclosure: No positions at time of writing.

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