Muni exchange traded funds

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A small but growing corner of muniland consists of municipal bond exchange traded funds (ETFs). I know very little about these products and asked Matt Tucker, a managing director on BlackRocks fixed income portfolio management team, to write a short introduction to the product.

ETFs: The new way to access the municipal bond market

Traditionally, the only two options available for those who wanted to invest in the municipal bond market were through mutual funds or laddered bond portfolios. In the past five years, though, exchange traded funds (ETFs) have come on to the scene. They provide a combination of diversification, index performance and exchange liquidity, making them a compelling addition to anyones municipal bond investments.

Like other funds in the market, ETFs offer diversification, a challenge to achieve for individual bondholders. Bonds generally trade in lots of 10,000 par or more, making it difficult for all but the wealthiest investors to build good, diversified portfolios. The share of the muni market that was AAA-rated fell from 70 percent in 2007 to 15 percent today, as a result of the demise of the bond insurance companies over the past few years. As a result, there is much more default risk in the current market. Muni ETFs generally hold hundreds of positions, and shares of the ETF can be obtained for the price of a single share of a single fund, often as low as $50. Like individual bonds, the holdings are visible, meaning that most ETF providers allow investors to see fund holdings on a daily basis. This provides investors with the comfort of knowing what they own.

In terms of performance, the majority of municipal bond ETFs in the market are index funds. According to a Standard & Poor’s study released at year-end 2011 that examines the performance of active funds, 90 percent of national municipal bond funds underperformed their benchmarks over the past five years. Index ETFs are generally not the highest-performing funds in a given period, but they have also not been the lowest. This can make them a compelling alternative for investors looking for more consistent performance in their municipal bond portfolio.

Liquidity has long been a challenge for investors in individual municipal bonds. Municipal bond trades are negotiated between parties in an over-the-counter market, without the benefit of a central exchange. As a result, transaction costs can be high, often 200 or more basis points. This can have a significant impact on investor yield. Investors who hold individual bonds often face challenges with liquidity, both in finding the right bond to buy and also in getting a good price if they want to sell. Because ETFs trade on an exchange, investors can observe price movements, trading volumes and bid-ask spreads throughout the day, just as equity traders can. Investors can also place orders as they do for an equity security, including using equity market trading strategies like limit and stop orders.

The introduction of muni ETFs has provided investors with a valuable new tool for investing in and managing their municipal bond portfolio, a low-cost way to create diversification, obtain core market exposure and access liquidity as needed.