Muni bonds are issued by states, cities and other local governments to raise money for projects such as schools, bridges, water systems or other initiatives.
They generally fall into two categories: general obligation bonds and revenue bonds. General obligation bonds are issued by local governments, which use tax revenue to repay them. Meanwhile, holders of revenue bonds are repaid from the revenue generated by the project that was initially funded.
Wealthy investors in higher tax brackets are attracted to muni bonds because the interest income is usually exempt from federal income taxes. The interest income may also be exempt from state and local taxes if the purchaser is a resident of the city or state in which the bonds were issued.
ETF heavyweights Barclays Global Investors and State Street Global Advisors have introduced the first funds tracking the muni bond market, and more are in the works.
BGI launched iShares S&P National Municipal Bond Fund
(MUB:
ishares trust s&p natl mun b
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99.95, -0.09, -0.1%) on Sept. 10, just days ahead of State Street. The ETF, which has an expense ratio of 0.25%, seeks to track the price and yield performance of a muni bond index calculated by Standard & Poor's that recently had more than 3,000 issues.
The benchmark includes muni bonds primarily issued by state or local governments with interest that is exempt from federal income tax and the alternative minimum tax, or AMT, which applies to higher-income investors. The bonds must have a rating of at least BBB- from S&P and Fitch, and Baa3 from Moody's Investors Service. Each bond must have a minimum par amount outstanding of $50 million, according to the prospectus.
However, iShares S&P National Municipal Bond Fund will hold substantially fewer muni bonds than the tracking index -- it had 39 holdings as of Sept. 18, according to BGI.
Although the muni bond market is vast with more than 1 million individual bonds and in excess of 50,000 issuers, it's much more fragmented than the corporate and Treasury markets, said Matt Tucker, head of fixed-income investment solutions at BGI.
Also, there's less transparency in pricing and it's tougher to measure liquidity, he said.
"Muni bonds tend to be bought and held by investors, so they don't enjoy as much secondary trading and liquidity," Tucker said. "This creates a challenge for creation and redemption," he added, referring to the unique process by which ETF shares are produced or eliminated based on market demand.
State Street Global Advisors listed the SPDR Lehman Municipal Bond ETF
(TFI: SPDR Lehman Municipal Bond ETF
The ETF follows the Lehman Brothers Municipal Managed Money Index, which tracks over 22,000 issues in the most liquid segment of the muni bond market, according to Boston-based State Street. The average credit quality of the muni bond in the index is AAA or Aa1, depending on the ratings agency, and none of the bonds are currently subject to the AMT, according to State Street.
Like the BGI offering, SPDR Lehman Municipal Bond ETF will sample the index, which may result in tracking error. The ETF had 28 holdings as of Sept. 19, according to State Street.
Tony Rochte, a senior managing director at State Street, said the ETF brings more trading flexibility and lower fees than muni bond mutual funds, which have an average expense ratio of 1.1%. He said it was "one of the most highly demanded ETFs from institutions, financial advisers and self-directed investors."
Muni bond ETFs had faced "liquidity challenges" but now there should be a "flood of products to market," said James Ross, another senior managing director at State Street.
BGI, State Street, PowerShares Capital Management and Van Eck Global reportedly have more muni bond ETFs in registration, including products focusing on individual states such as New York and California.
Most ETFs track stocks, but providers are rolling out more bond funds. At the end of July, there were 539 ETFs listed on U.S. exchanges, but only 30 tracked bond indexes, according to Investment Company Institute. These cover Treasurys, corporate bonds, mortgages, TIPS and high-yield. Also, investors have been calling for ETFs tracking foreign bonds, particularly emerging markets debt.
Industry observer Jim Wiandt, editor of the Journal of Indexes, said although muni bond ETFs "fill an obvious empty spot," he's not sure how much demand there will be for the products. ETFs are priced throughout the day like individual stocks, but some wonder if investors will want to trade muni bonds rapidly.
Also, Wiandt questioned how important diversification is for muni bond investors, who are attracted primarily to the income. Still, the appearance of muni bond products suggests ETFs may soon be able to breach other traditionally illiquid asset classes, he said.
John Spence is a reporter for MarketWatch in Boston.
