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By The ETF Professor

Detroit, once the fourth-largest U.S. city, filed for Chapter 9 bankruptcy protection Thursday, marking the largest municipal bankruptcy in U.S. history. The Motor City has $18.5 billion in long-term debt, and news of Detroit's bankruptcy has predictably cast a dark cloud over the already fragile municipal bond market.

Uncertainty about the Federal Reserve's plans to taper quantitative easing and a recent rise in 10-year Treasury yields have hampered municipal bond ETFs. Detroit's bankruptcy has provided an excuse for sellers to ding some of the largest municipal bond ETFs Friday. The iShares National AMT-Free Muni Bond ETF (NYSEARCA:MUB), which has over $3.3 billion in assets under management, is off 0.6 percent while the $897.6 million Market Vectors High-Yield Municipal Index ETF (NYSEARCA:HYD) is lower by 1.4 percent.

The SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEARCA:HYMB) is down one percent while the Market Vectors Long Municipal ETF (NYSEARCA:MLN) has shed two percent.

The thing is none of these ETFs offer remotely significant exposure to Michigan. State weightings in HYD, the high-yield product, range from 1.6 percent for Wisconsin at the bottom of the states listed by Market Vectors to 7.9 percent for New Jersey at the top. Michigan the state, not Detroit the city, accounts for a scant 2.4 percent of HYD's weight.

MLN, the other Market Vectors ETF mentioned here, lists 18 states, Puerto Rico and Washington, D.C. among its top-20 geographic holdings, but Michigan is nowhere to be found on that roster.

The top 10 geographic weights in the iShares National AMT-Free Muni Bond ETF, which include nine states and Puerto Rico, represent 77.6 percent of that ETF's weight. Michigan is not among that group. In other words, the Detroit bankruptcy is significant for the city, Michigan and residents, but the news is a non-starter for muni bond ETFs. The funds' weights, or lack thereof, to Michigan prove as much.

That does not mean muni bond ETFs could not be dealt blows in the future at the hands of more, potentially larger, municipal bankruptcies. As Fox Business reported last month, several California cities have already filed for bankruptcy and others are on the brink. The big problem will be exposed when new accounting standards force California to show the world the truth: Nearly $329 billion, roughly 10 times the size of General Mills (NYSE:GIS), in unfunded pension liabilities.

While various media outlets were busy heaping praise on the California Public Employees' Retirement System (CalPERS) for a good year of equity portfolio returns, it was noted that CalPERS' stock picking was trumped by any number of low-fee ETFs.

The reality is with a soaring number of retirees receiving pensions of $100,000 a year or more, CalPERS money managers need to perform better than they have been.

The roughly $3.7 trillion muni bond market demands it. In more docile environments for munis, the typical default rate is scant. However, if issues such as the fiscal cliff, rising interest rates and Detroit's bankruptcy have pressured muni bond ETFs, imagine what would happen if Los Angeles and/or San Francisco went bankrupt.

Events like that would like crush MUB, which has a 22.7 percent weight to California. MLN, with a 12.1 percent weight to California, would be vulnerable, too. And it is reasonable to assume the $283 million iShares California AMT-Free Muni Bond ETF (NYSEARCA:CMF), an all-California fund, would be decked as well.

Again, Detroit's bankruptcy is bad news, but investors in muni bond ETFs have options. Investors can hope major California and New York cities do not travel the same path as Detroit or opt for those funds that have limited exposure to the most financially vulnerable states.

Disclaimer: Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation.

Source: Go Beyond Detroit For Muni ETFs' Real Potential Problems