Invesco Powershares is preparing to launch an exchange-traded fund linked to Build America Bonds, fusing two of the hottest ideas in public finance.

Earlier this month, Invesco filed a prospectus with the Securities and Exchange Commission registering a BAB ETF.

The fund will seek to replicate the Merrill Lynch Build America Bond Index, which measures the performance of a basket of BABs of at least $1 million.

Enacted in the American Recovery and Reinvestment Act in February, the BAB program enables state and local governments to sell taxable bonds and, in lieu of paying investors tax-exempt interest, collect a federal subsidy equal to 35% of the interest costs.

Issuers have sold $33.6 billion of BABs since the first batch hit the market in April, according to Bloomberg LP.

The ETF will invest at least 80% of its money in bonds included in the Merrill Lynch index. The prospectus did not say how much money the fund will launch with or when it will launch.

The fund will be run by a team of managers, including Phil Fang, who runs Invesco’s other muni ETFs.

In the section of the prospectus enumerating the risks associated with investing in the fund, Invesco points out that the BAB program expires at the end of next year, raising the prospect of limited supply.

If the program sunsets, the ETF plans to shift its strategy generally to taxable municipals.

This latest fund comes at an exciting time for muni ETFs. A novel product at the end of 2007, they have since accumulated $4.44 billion in assets, according to the Investment Company Institute.

The sector is on fire. Six of the 18 muni ETFs yesterday notched their fattest prices since launching, and most have touched their highs in the past few weeks.

The biggest muni ETF — iShares S&P National Municipal Bond — has swelled to $1.34 billion in assets.

The BAB exchange-traded fund would be the 19th.

The 18th launched this morning. State Street Global Advisors’ newest ETF invests in municipal variable-rate debt obligations, capitalizing on what it described as growing demand for VRDOs.

The SPDR Standard & Poor’s VRDO Municipal Bond ETF, ticker symbol VRD, kicked off yesterday with $6 million in seed money.

In a statement, State Street managing director James Ross said more people want to buy VRDOs, but they are often sold in denominations of at least $100,000. This ETF can offer those investors access to the product without requiring such a hefty commitment, he said. A share costs about $30.

VRDOs are long-term bonds that behave like short-term bonds because their interest rates are reset at regular intervals, such as weekly, by a remarketing agent. They are typically backed by some kind of guarantee from a bank, meaning the owner of the bond can force the bank to buy the VRDO at face value.

An ETF is a share of ownership in a trust. The shares trade on a stock exchange, theoretically tethered to the value of the trust.

The trusts supporting ETFs usually seek to mimic the performance of a benchmark, such as the price of gold or the Standard & Poor’s 500 Index. The State Street ETF will strive to mirror the Standard & Poor’s National AMT-Free Municipal VRDO Index, which launched just a day earlier.

With 377 issues, the index tracks more than $30 billion in municipal VRDOs with rates that reset weekly. The biggest issues in the index are New York’s Metropolitan Transit Authority, the Lower Alabama Gas District, and the Illinois State Toll Highway Authority.

Like most of the other muni ETFs, the SPDR VRDO fund will attempt to replicate an index with far more securities than the trust itself can afford to buy.

This creates what is known as tracking risk: the risk that a trust with $3 million to invest will not be able to reproduce faithfully the performance of an index comprising more than $30 billion in bonds.

The fund tries to accomplish this feat through a process known as sampling, which means using quantitative analysis to fill a trust with securities whose characteristics in aggregate are similar to a bigger group of securities.

If that sounds difficult, it is: during the credit crisis last year, many muni ETFs became unmoored from the indexes they were designed to mimic.

This is not the first ETF created to track muni VRDOs. In 2007, Invesco launched the Powershares VRDO Tax-Free Weekly, ticker symbol PVI, which strives to mime the Thomson Reuters Municipal Market Data VRDO ETF Index.

The fund has grown to $826.4 million in assets.

If the Powershares ETF is any indication, the SPDR VRDO fund is not in for much volatility. The price of the Powershares ETF stays within a very tight band, rarely moving by more than a penny or two a day.

Invesco attributes this to the weekly rate resets in the debt it buys and the right to sell the debt to a bank on short notice, both of which render the securities short-term and low-risk. Invesco acknowledges that its VRDO ETF is similar in ways to tax-free money market funds, which are the primary buyers of VRDOs.

Timothy Ryan, head of SSGA’s muni group and a portfolio manager for the ETF, said this fund offers a key advantage over tax-free money market funds: ETFs are not bound by Rule 2a-7, which imposes strict limits on what money market funds can buy. Because the ETF can buy some of the VRDOs ineligible for purchase by money market funds, he said it may be able to offer a better yield.

Ryan said he could not guess what monthly dividend the ETF will pay because the rates are frequently resetting.The index the ETF strives to replicate carries a weighted average yield of 0.55%.

State Street now has five muni ETFs with about $1.4 billion in assets, including a California fund, a New York fund, and a short-term fund.

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