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By Timothy Strauts

Historically, municipal bonds have been one of the quieter corners of the investment world. Sure, there was the occasional single-municipality meltdown, such as what happened to Orange County, Calif., in 1994. Still, what made these events so newsworthy was the actual rarity of these kinds of disasters. That has all changed as municipalities have been blind-sided by falling tax receipts in the wake of the housing crash. Defaults are still rare because of the stigma associated with defaulting. As more municipalities have trouble meeting their obligations, they will have to make a choice between making interest payments or paying for basic services like firefighters.

One way to reduce the risk of municipal defaults is to own a diversified national municipal bond fund like iShares S&P National Municipal Bond ETF (NYSEARCA:MUB). While an increase in defaults is likely, the diversification inherent in the fund will help cushion the blow. Aggregate bond indexes such as iShares Barclays Aggregate Bond (NYSEARCA:AGG) and Vanguard Total Bond ETF (NYSEARCA:BND) do not include municipal bonds in their holdings.

Municipal-bond funds in general are most suitable for use by investors in high annual tax brackets for use in their taxable accounts. The reason is that interest income from municipal bonds is tax-free at the federal level. Therefore, investors with the highest marginal tax rates are able to best utilize the tax-shielding profits and maximize their return on the bonds.

As part of a broader investment structure, investors may also wish to incorporate a muni-bond fund such as MUB in their muni-bond laddering strategy as a complement to single-issue holdings. Individual municipal bonds are fairly illiquid after they've been issued given most investors' preference to buy and hold them until maturity. Given that, holding a percentage of your municipal-bond allocation in the more-liquid ETF form will give you the ability to sell if you get in a jam--without the risk of getting gouged by the trading spread.

Fundamental View
In the past year the municipal market has had liquidity issues. A major factor that is limiting liquidity is that some major muni-bond dealers are holding less inventory than they have in the past. The infamous "Volcker Rule" seeks to rein in risk-taking by limiting the proprietary trading at banks. Maintaining an inventory of bonds available for sale is considered proprietary trading, so the major dealers have started reducing the size of their inventory in anticipation of the new rule. While many speculate that the rule will not be implemented in its current form, the fear of the law's current structure is enough to curb market participation. The net effect of these three factors has created a situation where the bid-ask trading spreads on bonds have widened dramatically.

The current municipal market is quite different than markets of the past. Municipalities have budgetary problems that will not be easily worked out. The housing boom was a major source of income for most municipalities as property values rose, populations increased, and fees for permits and other services provided substantial sources of revenue. Now that housing has crashed, municipalities are facing tough times while they work to cut costs to match lower revenues. In June 2010, Warren Buffett commented about the current state of municipalities by saying, "There will be a terrible problem and then the question becomes will the federal government help. If the federal government will step in to help them, they are triple-A. If the federal government won't step in to help them, who knows what they are." Most municipal bonds are still very highly rated and there have been few downgrades, but Warren Buffett's comments speak to growing concerns among investors.

MUB has a current SEC yield of 1.76%, so an investor in the 35% tax bracket is getting a tax equivalent yield of 2.7%. With the 10-year U.S. Treasury bond paying a yield of 1.7%, you're getting 1% of additional tax-equivalent yield. The credit issues of municipals are not an impending panic that will hit the market all at once like the Greek sovereign-debt crisis. Each municipality has its own unique and varied issues that will be confronted on their own schedule. Owning a diversified fund like MUB will help smooth out any issues an individual issuer runs into.

Portfolio Construction
IShares S&P National AMT-Free Municipal Bond tracks the S&P National AMT-Free Municipal Bond Index. The fund uses representative sampling, holding 2,056 of the 9,070 bonds in the underlying index. The fund's maturity schedule is distributed fairly equally in five-year buckets ranging from one to 25-plus years. Overall, the fund has an adjusted duration (a measure of interest-rate sensitivity) of around six years. The interest payouts on all of its holdings are exempt from federal income taxes, and none of them will trigger the Alternative Minimum Tax.

The states with the top allocations in the index are California (22%), New York (19%), Texas (8%), Puerto Rico (6%), New Jersey (5%), and Massachusetts (5%).

This fund charges a management fee of 0.25%, standard for municipal-bond ETFs. The estimated holding cost of MUB is currently negative 0.01%, which means the fund has been outperforming its index recently. Considering the illiquid nature of the municipal market, periods of small outperformance and underperformance are to be expected.

MUB is the largest and one of the more liquid municipal-bond ETFs. There are a multitude of other offerings that provide state-by-state exposure and also target more specific maturity ranges. Those looking for a twist on this sector may wish to look at PowerShares Insured National Muni Bond (NYSEARCA:PZA). It has expenses of 0.28% and offers exposure to insured municipal debt with a duration similar to MUB's. The other main competitor is SPDR Nuveen Barclays Capital Municipal Bond (NYSEARCA:TFI). It has expenses of 0.23% and a longer duration of eight years.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.