Have you considered investing in pre-refunded munis? If you are asking yourself what the heck is a pre-refunded muni, then you are not alone. Although “pre-res” have been around for years, their availability has generally been limited to institutional investors. Now they are accessible to all with the introduction of the Market Vectors Pre-Refunded Municipal Index Fund (NYSEARCA:PRB).
Pre-refunded munis are generally backed by U.S. Treasury securities held in escrow, putting their credit quality on par with direct Treasury investments. You cannot find this unique combination of tax-free income and Treasury credit quality anywhere else.
When interest rates drop, many homeowners and borrowers like to refinance their debt at the new lower rates. The same is true for states and municipalities. However, unlike the homeowner who pays off his existing loan with a new loan, most municipal debt obligations cannot be “called,” or retired, at the same time the new bond is issued.
Instead, municipalities use the proceeds from the new bond sale to buy Treasury securities with maturities similar to the “call date” of the original bond. The Treasury securities are held in escrow to pay off the original loan when the call date arrives.
Muni yields relative to Treasurys are at historically high levels because current market turmoil has increased the risk of default. That risk essentially goes away with pre-refunded munis. As a result, the yields on pre-refunded munis are much lower than other muni segments.
The fund’s underlying index, the Barclays Capital Municipal Pre-Refunded Treasury Escrowed Index, has shown relatively low correlation to both traditional muni indexes and Treasurys. The Treasury backing also makes this an extremely liquid asset class.
The average maturity of the holdings is less than five years, which should help the fund’s price stability. Current tax-free yield is expected to be just under 2%, and expenses are capped at 0.24%.
The Van Eck Global website has additional background material, including an informative piece called The Investment Case for Pre-Refunded Municipal Bonds.
With this new ETF, Van Eck is making a new asset class available to the individual investor. PRB looks like the right product at the right time.
- Read PRB's prospectus [pdf]
Disclosure: No positions