New High-Yield Muni ETF Isn't Like Other Junk Issues

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Includes: HYD, MLN
by: IndexUniverse

While high-yield bond exchange-traded funds have proved to be popular with investors in recent years, similar options for muni investors haven't been so plentiful. The only available high-yield muni funds have been either in the closed-end marketplace or through traditional open-end mutual funds.

But that has changed. The Market Vectors High-Yield Municipal Index ETF (NYSEARCA:HYD) was launched on Feb. 5, becoming the first of its kind in the ETF marketplace. It's expected to wind up with an annual expense ratio of 0.35%.The average high-yield muni mutual fund charges 0.63%, according to Morningstar.

"The muni high-yield segment is very interesting and has real potential in the format of an ETF," said Harvey Hirsch, a senior vice president at Van Eck Global. "About 10% of the muni market is now represented by high-yield issues."

HYD is the fifth muni ETF now out by Van Eck Global. Its index was created by Barclays and had about 4,204 different bonds entering 2009 with a market value of $101 billion. The average coupon in the index was about 5.82% and the average duration was 8.63 years.

Perhaps more important for investors is the fact that the portfolio's yield is starting out at a quite-attractive 9.35%. By comparison, the Market Vectors Long-Term Municipal Bond ETF (NYSEARCA:MLN) has a yield of 5.71%.

"There's a significant spread now between long-term investment-grade munis and high-yield munis," said Jim Colby, senior municipal strategist and portfolio manager at Van Eck Global.

In fact, yield spreads on muni high-yield bonds are now at historically high levels compared to investment-grade munis, he added. The average spread between the two, based on long-term performances of two Barclays bond indexes, has been about 242 basis points. At the end of 2008, that differential was 636 basis points.

"There would appear to be significant opportunity for those willing to assume the added risks of investing in high-yield munis now," said Colby.

In the rolling 10-year period ending June 30, 2008, the taxable equivalent return on high-yield munis topped all other categories of munis, he added. "And high-yield led by a very wide margin," Colby noted.

High-yield munis had a difficult second half of 2008. "The auto industry, airlines and paper industries that are fairly recognizable in the corporate equities indexes are also components of high-yield indexes," said Colby.

While corporate high-yield bonds have held higher correlations to stocks in the past, that hasn't been true with muni high-yield issues, contends Van Eck.

"Investment-grade municipal bonds have far less correlation to the equity market than municipal high-yield. The corporate component of HYD is in the order of 25% to 30%," said Colby. "That should be much less than a high-yield bond fund, which likely will hold a majority of its portfolio in corporate issues."

And the commonly used term for the category, junk bonds, doesn't necessarily apply to munis, points out Colby. He notes a Moody's study showing that historical default rates on high-yield munis run about 4.3% on an annualized basis. By comparison, high-yield corporate default rates come out about 32.7%.

"Muni high-yield bonds have different characteristics than they do in the corporate world," said Colby.

-- This article was submitted by IndexUniverse.com's Murray Coleman.

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