When was the First Municipal-Bond ETF (Exchange Traded Funds) Launched?
Traditional ETF's date back to 1993 when the American Stock Exchange listed the first EFT "Spiders" - S&P Depositary Receipts. In September of 2007, Barclays launched the first municipal bond ETF. It took over 14 years for municipal bonds ETF's to become available to the public. The tax-exempt muni-bond market has lacked real-time pricing until recently. Just this year technology was introduced for the first time to price government debt securities every 15 seconds. This new technology will promote the availability of municipal bond ETF's and streamline the marketplace. Currently there are over 18 municipal bond ETF's available through four major competitors and they are gaining popularity amongst investors every day.
What is a Municipal - Bond ETF?
Municipal Bonds are debt issued by state or local governments to finance public projects like schools, highways, hospitals, correctional facilities, and many other projects for the public good. When you purchase a municipal bond, you are lending money to an issuer who promises to pay you a specified amount of interest and return the principal to you on a specific maturity date. The income from a municipal bond is exempt from federal income tax, and in most cases it is exempt from state and local taxes. Municipal Bond ETF's provide coupon payments and mirror the returns of a particular index. The most popular index for benchmarking municipal bond ETF's is the Lehman Brothers Municipal Managed Money Index which was launched in 2004. Like real bonds, the ETF is worth more when interest rates decline and less when rates rise. But while bonds mature and return your initial investment, your investment in the municipal bond ETF fluctuates in the same way as it does in stocks. Investors can buy and sell ETF shares throughout the day on a stock exchange.
What are the Cost and Potential Yields of Investing in Municipal-Bond ETF's?
Municipal bond ETF's are easy and relatively inexpensive to get broadly diversified exposure in the tax-exempt market. The main attraction of investing in these new funds is the rock bottom cost. The fees can range anywhere from 0.07% to 0.34% depending on the fund structure. The fees compare favorably with an average expense ratio of 1.02% for all national tax-free bond funds, which invest in local- and state-government debt. Thanks to their low expenses, muni-bond EFTs offer very attractive yields. As with other debt investments, the longer the duration of the bond the higher the yield return. In other words investors get compensated for taking on more risks.
How Important is the Credit Quality of the Underlying Municipal Bonds?
Credit quality is also a concern when it comes to municipal bonds. Bonds are usually included in investors' portfolios to help diversify risk away from the more volatile returns of the other securities in their portfolio. Municipal bonds have more risk associated with them than U.S. Treasury bonds, primarily because the tax base backing them is much smaller. If investors choose to invest in municipal bond ETF's they should consider the credit quality of the underlying bonds.
What is the Risk of Owning Exchange Traded Funds?
Municipal securities are subject to several kinds of risk including: legislation, changes in taxation, credit risk, political events, and even bankruptcy. Another risk for muni-bonds is the potential for credit downgrades to below investment grade. Municipal bonds issued by Detroit and New Orleans have experienced credit downgrades recently. In addition to the changes in the financial condition of a municipal insurer the conditions of the market in which the project was financed can have an affect on the overall municipal market.
Conclusion
The Municipal Bond market is a highly fragmented market of over 50,000 different bond issues. The fragmentation of this market has caused problems in the past with the creation of a viable municipal Bond ETF. The tax-efficiency of the muni-bond ETF has made it an attractive vehicle over mutual funds because they don't realize gains or losses when selling securities. Municipal bond ETF's are so new to Wall Street and lack any substantial return history. It will be interesting to see how successful the muni-bond ETF's are in the future.
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