Buy Side

Muni ETFs' First Year a Hard One

Municipal bond exchange- traded funds have suffered a baptism by fire in their first year of existence.

Heralded as liquid, transparent, low-fee mechanisms for investing in tax-exempt municipal debt, muni ETFs in their first year have faced historic illiquidity and the implosion of the bond insurance industry.

The market tumult has at times waylaid the ETFs' primary goal of linking price to an underlying muni index like the Merrill Lynch U.S. insured core municipal securities index or the Thomson Municipal Market Data VRDO index.

ETF managers say while prices have occasionally untethered from the indexes they are designed to track, the fledgling product has held up well given the volatility and illiquidity plaguing the muni bond industry.

Four companies - Barclays Global Investors, State Street Global Advisors, Invesco Powershares, and Van Eck Global - have launched 15 muni ETFs since September 2007.

Through quantitative analysis, muni ETFs try to mirror their indexes by holding a sampling of bonds in the indexes. Barclays' iShares S&P National Municipal Bond Fund (MUB), for example, holds 159 securities in trying to track an index composed of 7,550 issues.

The ETFs collect the coupon payments from the bonds they hold and distribute them as dividends, typically monthly or quarterly.

The iShares National Municipal Bond Fund currently yields an annualized dividend of 3.8%, for example, while the PowerShares Insured National Municipal Bond Portfolio (PZA) yields 5%.

Matthew Tucker, head of fixed-income investment strategy at Barclays Global Investors, said muni ETFs offer greater diversity than individual muni bonds. Selecting muni bonds can leave an investor exposed to a single default, whereas an ETF spreads the risk, he said.

Muni bond mutual funds, meanwhile, typically charge higher management fees and offer pricing updates once a day. Municipal bond ETFs use a pricing service, Interactive Data Corp., to update asset values as often as every 15 seconds.

ETFs do not promise fat returns; they merely strive to reflect the performance of their underlying indexes.

During market disruptions, this design faces two risks: the value of an ETF's bond sampling failing to reflect the overall index, or the price of the ETF on the exchange unmooring from the value of its assets.

The price of Van Eck Global's market vectors long municipal index (MLN) has deviated from the value of its assets by more than 2% 14 times since its inception in January.

At the end of October, State Street Global Advisors' SPDR Lehman Municipal Bond ETF (TFI) was down 4.5%for 2008, even though the index it tracks was down only 3.8%.

The discrepancy with State Street's state-specific funds was even wider: The SPDR Lehman California Municipal Bond ETF (CXA) was down 7.1% for the year as of the end of October, while its index was down only 5.8%. The SPDR Lehman New York Municipal Bond ETF (INY) was down 6.9%, compared with a drop of 5.4% for its index.

The SPDR Lehman Municipal Bond ETF, which invests in long-term munis, yields 4.6%. The California and New York funds respectively yield 4.6% and 4.9%.

Through its iShares brand, Barclays runs four ETFs, including one launched this month even as markets remain in the throes of a crisis.

"We've seen some larger-than-normal tracking errors, but we've been very pleased with how the funds have tracked to their indices considering the level of market volatility," said Tucker.

The iShares S&P National Municipal Fund, with $750.6 million in assets, on the last day of September eclipsed its tracking index by more than 5%.

"We generally would not expect to see that much fluctuation," Tucker said. "It's really just a matter of the level of volatility within the market. As it increases price fluctuations in securities, it's going to lead to generally higher tracking errors."

Over the last three months, iShares' three major ETFs' assets have all performed within at most 0.7 percentage points of their underlying indexes.

Meantime, James Colby, senior municipal strategist at Van Eck Global, said even with wild gyrations in the market and the freezing up of the short-term credit market, ETFs were open for business.

"I'd have to say that I think the ETFs have performed and stood up admirably, stood up pretty darn well," said Colby.

Colby co-manages three muni bond ETFs for Van Eck: one for short maturities, one intermediate and one long.

Eight times since the beginning of September the intermediate ETF's price has drifted more than 2% from its net asset value, or NAV. Each time, it reverted back toward correlation. The ETF currently trades at a 0.3% premium to its assets.

Van Eck's three funds illustrate how ETFs can give investors access to trading strategies for tax-exempt credit while maintaining price transparency and trading liquidity.

Van Eck's long-term municipal bond fund has taken a drubbing since its inception in January, sinking 17% as buyers have fled to liquid investments like cash or Treasuries. Its medium-term fund is down about 5%. Its short-term fund, meanwhile, is essentially unchanged during a year in which the Standard & Poor's 500 Index has tumbled 40%.

"Our short ETF is designed exactly to do what it has done, and that is provide income and some protection against wild gyrations in the market," Colby said.

The long index, meanwhile, carries "significantly more interest rate risk."

"We've had nothing but significant interest rate risk in the last few months," he said.

The stability of the short ETF has also been reflected in the relationship of its assets to its price: Its price has never deviated more than 2% from NAV. Meanwhile, the long ETF has drifted by more than 3% six times.

The annualized yield on the short, intermediate and long funds are, respectively, 2.9%, 4%, and 5.6%.

State Street's long and short funds showed a similar dynamic. While as of the end of last month the long fund was down 4.5% for the year, the SPDR Lehman Short Term Municipal Bond ETF (SHM) was up 2.2%.

Philip Fang, fixed-income portfolio manager for Invesco PowerShares, said on several occasions his funds have slightly mismatched their indexes because of new investments.

When people pour money into the ETFs, PowerShares buys newly issued muni bonds to back the creation of new shares. The value of the index the fund is meant to track does not include those new bonds until the next rebalancing, he said, creating a lag between the fund and the index.

William Larkin, a portfolio manager at Cabot Money Management, said he likes muni bond ETFs because they are easy to sell if he wants to move into a different investment. Also, he can gain exposure to tax-exempt debt without having to research individual muni credits.

Larkin said he has probably bought all 15 muni bond ETFs, with the iShares S&P National Municipal a "staple" in his clients' portfolios.

Muni bond ETFs vary mainly in two categories: by maturity and by location. ETFs offer exposure to indexes following municipal credit in California and New York.

Barclays' Tucker said investors have asked him for ETFs tracking municipal credits in other states, and Larkin said he would be interested in ETFs focusing on other regions. Tucker said investors have also asked for a high-yield municipal bond ETF.


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