After years of anticipation, and in some cases goading, by shareholders, investors and other members of the financial community, three major exchange-traded fund sponsors have finally brought municipal bond ETFs to market.
To understand what all the fuss is about, it helps to understand the unique benefits of a municipal bond, particularly to investors looking to generate tax-free income. A municipal bond is a fixed-income security issued by a state, county or municipality to fund a large capital expenditure. Just like a corporate or a Treasury bond, a municipal bond has a par value, a coupon rate and a maturity date. Municipal bonds are typically used to fund large road-building and public utility projects, schools, and even airports and shopping malls. But there is a key difference between municipal bonds, or “munis” as they are known to financial professionals, and their corporate and Treasury cousins.
Municipal bonds are attractive to many investors, especially to investors in the higher federal income tax brackets, because the income from these bonds is exempt from federal income tax. Income from muni bonds may also be free from state tax for bondholders who reside in the state of issuance. Note that there are some important exceptions to these general rules regarding the tax-exempt status of municipal bond income.
The first fund sponsor to bring a municipal bond ETF to market was iShares, which launched its S&P National Municipal Bond Fund (MUB) on September 7. A few weeks later, iShares followed up with its S&P California Municipal Bond Fund (CMF) and its S&P New York Municipal Bond Fund (NYF), both of which launched on October 4.
According to Joel Silva, municipal bond trader and portfolio manager for all three iShares muni bond funds, the vast, fragmented and frequently opaque municipal bond market itself was the biggest challenge to rolling out the new products. There are some 50,000 actively priced municipal bonds traded in the U.S., but there is no centralized locus of trading, and not all the bonds are suitable for individual investors. Silva and his team worked with Standard & Poor’s to create indexes that would give investors a good combination of credit quality, income and liquidity.
To build the index that underlies MUB, for instance, iShares screened out all bonds with par values below $50 million and any securities that were subject to the alternative minimum tax [AMT]. The yield on municipal bonds issued to fund commercial projects such as sports stadiums is not exempt from federal income tax but, rather, is subject to the AMT. Although these “AMT bonds” tend to have higher yields than fully exempt traditional muni bonds, the extra income does not always offset the federal tax. Issues below the $50 million level tend to price less frequently, says Silva, and thus present a potential liquidity problem for investors.
The S&P National Municipal Bond Index tracks 3,069 securities, according to the MUB prospectus, but the fund itself uses a “representative sampling” methodology to approximate the index and held just 36 muni bonds as of October 26. One of the advantages of this approach is that it makes the job of the authorized participants [APs] — the specialists and brokerages that make a market in MUB shares — a little bit easier. To create and redeem shares in the fund, an AP needs to assemble a basket of only a few dozen—rather than several thousand securities.
All the new iShares municipal bond funds use the “in-kind” creation and redemption process that investors have come to associate with ETFs. These tax-neutral exchanges of shares don’t generate capital gains, and they also allow the fund to flush out the low-cost-basis bonds that would throw off the most capital gains when sold. Each of the new iShares funds charges an annual fee of 0.25 percent.
In contrast, the new line of muni bond ETFs from State Street Global Advisors — SPDR Lehman Municipal Bond Fund (TFI), SPDR Lehman Short Term Municipal Bond Fund (SHM), SPDR Lehman California Municipal Bond Fund (CXA) and SPDR New York Municipal Bond Fund (INY) — uses cash in the creation process. These funds are so new (they launched on October 11) that it is not yet clear what the tax implications of State Street’s cash-for-shares creation process will be. With the exception of TFI, which charges 0.30 percent in annual fees, State Street’s new funds have a slight edge over the iShares products on price, charging 20 basis points a year in expenses.
PowerShares is the third sponsor with a new family of muni bond ETFs. The Insured National Municipal Bond Portfolio (PZA), the Insured California Municipal Bond Portfolio (PWZ) and the Insured New York Municipal Bond Portfolio (PZT) will reportedly also use cash in both the share creation and redemption processes. Each of these funds carries an annual expense ratio of 0.28 percent. What sets these products apart from the competition is that they hold insured bonds, i.e., the interest and principal payments are guaranteed by a third-party underwriter. In exchange for this guarantee, insured bondholders typically accept a lower yield on their investments.
Van Eck, a boutique ETF sponsor known for its targeted sector funds, has six muni bond funds in registration.