5 Quality-Rated Tax-Free Municipal Bond ETFs

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Includes: MUB, SHM, SMB, SUB, TFI
by: David Zanoni

It is a pleasure to know that there are tax free investments available. Municipal bonds offer this attractive feature for those interested in generating income from yields that are exempt from federal income taxes. Municipal bond exchange traded funds (ETFs) provide investors with a collection of muni bonds under one ticker. I have compiled a list of the highly-rated bond ETFs with credit ratings concentrated primarily with AAA, AA, and A.

SPDR Nuveen Barclays Capital Muni Bond (NYSEARCA:TFI)

TFI has a bond rating breakdown with 22% rated AAA and 78% rated AA. It has a yield of 3.1%, with a net expense ratio of 0.23%.

Top Holdings as of June 29, 2012

% Assets

Salt Riv Proj Agric Impt & Pwr Ref Re 5%

1.24

Triborough Brdg & Tunl Auth 5%

1.24

Milwaukee Wis Go Prom N 5%

1.18

Washington St Var Purp 4%

1.13

California St Dept Wtr Res Pwr Pwr Su 5%

1.09

Los Angeles Calif Go Ref Bd 5%

1.08

Washington St Go Ref Bd 5%

1.04

San Francisco Calif City & Cnt Ref Co 5%

1.03

Palm Beach Cnty Fla Pub Impt R Ref Bd 5%

0.95

At least 80% of assets are invested in municipal bonds that seek to track the Barclays Capital Municipal Managed Money Index. Although the credit rating is high, TFI also has a high interest rate sensitivity rating. The fund had a performance of 5.68% since inception in September 2007.

SPDR Nuveen Barclays Capital S/T Muni Bond (NYSEARCA:SHM)

SHM has a bond rating breakdown with 22.39% rated AAA, 77.5% rated AA, and 0.02% rated A. This ETF yields 1.36% and has an expense ratio of 0.20%.

Top Holdings as of June 29, 2012

% Assets

Virginia Comwlth Transn Brd Tr Trans 5%

1.23

Montgomery Cnty Md Pub Impt 5%

1.21

Delaware Transn Auth 5%

1.21

Arkansas St Fed Hwy G 4%

1.2

Maryland St Go Bds 5%

1.12

South Carolina St Go St Hig 4%

1.08

Houston Tex Util Sys Rev Comb Util 5%

1.06

New York St Go Bds 3%

1.02

Connecticut St Go Bds 5%

1.00

Ohio St Major New St Infrastru Rev Bd 5%

0.99

The strategy of SHM is to track the performance of the Barclays Capital Managed Money Municipal Short Term Index. The fund returned 3.75% since inception in October 2007.

Market Vectors Short Municipal Index ETF (NYSEARCA:SMB)

The breakdown of credit ratings for SMB are: 20.81% are AAA, 47.57% are AA, 23.42% are A, 0.21% are B, and 2.31% are listed as other. This ETF has a 1.8% yield and an expense ratio of 0.20%. Overall, the fund is rated medium for credit quality and low for interest rate sensitivity.

Top Holdings as of June 29, 2012

% Assets

Gwinnett Cnty Ga Sch Dist 4.5%

1.84

New York St Go Bds 3%

1.45

New Mexico St Severance Tax Supplemen 5%

1.41

Milwaukee Wis Go Prom N 5%

1.12

Texas Water Dev Brd St Revolv 5%

1.05

California St Var Purp 4%

1.04

New Hampshire St Fed Hwy Hwy Grant 5%

0.98

Clark Cnty Nev Sch Dist 5%

0.90

New Jersey Econ Dev Auth 5%

0.88

New York St Dorm Auth 5%

0.81

This fund is for those who believe that muni bond prices will fall. The fund's strategy is to replicate the performance of the Barclay Capital AMT-Free Short Continuous Municipal index. Distributions are paid monthly.

Tax Equivalent Yields

30-day yield 1.62%

Tax Rate 15%

1.91%

Tax Rate 25%

2.16%

Tax Rate 28%

2.25%

Tax Rate 33%

2.42%

Tax Rate 35%

2.50%

iShares S&P Short-Term National AMT-Free Muni Bond (NYSEARCA:SUB)

The rating breakdown is: 14.81% are rated AAA, 62.44% are rated AA, 18.22% are rated A, 2.75% are rated BBB, and 1.78% are listed as other. The fund has a yield of 1.17% and an expense ratio of 0.25%. Overall credit quality is rated high with interest rate sensitivity rated low.

Top Holdings as of July 18, 2012

% Assets

BLACKROCK LIQ FD MUNIFUND

2.54%

CALIFORNIA STATEWIDE CMNTYS DEV AU

1.24%

ILLINOIS ST TOLL HWY AUTH TOLL

0.84%

MICHIGAN ST BLDG AUTH REV

0.72%

MEMPHIS TENN ELEC SYS REV

0.71%

GREENVILLE CNTY S C SCH DIST I

0.71%

CONNECTICUT ST

0.68%

NEW MEXICO FIN AUTH ST TRANSN REV

0.61%

NEW JERSEY ST TPK AUTH TPK REV

0.60%

This fund seeks to replicate the performance of S&P Short Term National AMT-Free Municipal Bond Index™. The fund achieved a performance of 2.93% since inception in November 2008.

iShares S&P National AMT-Free Muni Bond (NYSEARCA:MUB)

Bond rating breakdown: 16.3% are rated AAA, 49.65% are rated AA, 26.17% are rated A, 5.07% are rated BBB, and 2.82% are listed as other. The fund yields 3.11% and has a net expense ratio of 0.25%. Overall the fund is rated medium for credit quality and high for interest rate sensitivity.

Top Holdings as of June 28, 2012

% Assets

California St Go Bds 6%

0.67%

North Tex Twy Auth 5.125%

0.36%

Puerto Rico Sales Tax Fing Cor Rev Bd 6%

0.36%

California St Go Bds 5%

0.33%

Greenville Cnty S C Sch Dist 5.5%

0.30%

Salt River Proj Ariz Agric Imp Elec S 5%

0.30%

New York N Y Go Bds 5.25%

0.29%

Illinois St Toll Hwy Auth 5%

0.27%

New York N Y City Mun Wtr Fin Wtr Swr 5%

0.26%

The fund seeks returns that correspond to the performance of the S&P National AMT-Free Municipal Bond Index™. The fund has achieved a performance of 5.5% since inception in September 2007.

Conclusion:

The higher the investor's tax rate, the more beneficial the muni ETFs are in terms of total return as compared to federal taxable income investments. By using ETFs instead of investing in a small handful of munis directly, investors are better positioned against the risk of default. As an example, Stockton, CA filed for bankruptcy this past June. There will most likely be other defaults in the near future. However, the bond funds in this list have higher ratings than other muni ETFs and own bonds across many municipals. By using muni ETFs, investors have their eggs placed in multiple baskets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.