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iShares Muni ETFs Can Help Investors Even in a Volatile Muni Market

Taken from iSharesblog.com

February 9, 2011


In Matt Tucker’s last post, he discussed the recent media coverage of the municipal bond market, and argued that, although it’s a good idea for muni investors to examine their level of risk in light of current market volatility, defaults shouldn’t increase to the catastrophic level some are predicting.

I’d like to talk now about the benefits that exchange traded funds can provide investors in municipal bonds, particularly when the markets are as volatile as they are at the moment.

For some, the muni market has become a no-buy zone. In a brief filed in January with the SEC, another ETF provider withdrew previously-filed registration statements for three new muni ETFs because of its view that market volatility could cause tracking error (or deviation of the fund’s return from the benchmark’s return). In other words, the firm postponed a product because it didn’t believe the product could be managed in this market environment (see the full story here). We disagree: iShares ETFs have not substantially deviated from their indexes despite market volatility. (Tracking error for all iShares muni ETFs has ranged from 0.02% to 0.36% for the period November 1, 2010 through January 31, 2011.)

As with other muni bond funds in the market, we have seen some redemption activity in our iShares muni ETFs. Those redemptions reflect sellers from the fund and market makers conducting arbitrage. But redemption activity can actually be a sign that the fund is healthy. Market marker arbitrage is essential in order for ETFs to function properly and drive down costs in the marketplace.

And despite the muni market dislocation of recent weeks, iShares muni ETFs have performed in line with expectations and delivered low tracking error. Between November 1and January 31, the largest iShares muni bond fund, the iShares S&P National AMT-Free Municipal Bond Fund (NYSEARCA:MUB) ($1.9 billion in AUM as of January 31, 2011) has had a tracking error of 0.22%. (Tracking error for the six-month period ending December 31, 2010 was approximately 0.33%, while tracking error for the year amounted to 0.66%.)  Please click here for standardized iShares fund performance for MUB.

Muni ETFs also provide valuable diversification. It isn’t easy at the moment to source bonds in the marketplace; building a diversified municipal bond portfolio from individual bonds would likely be costly and time-consuming. With MUB, investors can access over 1,100 holdings in a single trade; with the iShares S&P Short Term National AMT-Free Municipal Bond Fund (NYSEARCA:SUB), 480 holdings (both as of January 31, 2011).

Muni ETFs can also provide liquid access in a highly fluid marketplace. Since the start of the muni market volatility, MUB trading volume has spiked (see chart below); from November 1, 2010 through January 31, 2011, trading volume in MUB has increased by 270%. That level of activity demonstrates the value of actionable prices based on real-time valuations in a quickly moving market.  Higher trading volume means more participants in the marketplace, which leads to lower transaction costs for investors.

Another benefit of muni ETFs is their transparency. Because of it, iShares muni ETFs appear to be acting as a barometer for the muni bond market as a whole. Since last November, the price of MUB has consistently led the fund’s NAV—in other words, displayed a discount. It may sound counterintuitive, but a consistent discount to NAV since November is a sign that the fund is healthy. Because most bonds are traded over the counter, in fast-moving markets a fixed income ETF can respond faster to market sentiment than its underlying bonds. This process of price discovery can lead to a temporary discount in the fund’s price relative to its NAV. But as the underlying bonds catch up to reflect that market sentiment, the ETF’s price will generally realign with its NAV. Which means that the ETF price can be a truer reflection of market sentiment than the price of individual bonds.

This is a challenging time for muni investors, but it can be a rewarding one. Investors considering municipal bonds should consider iShares muni ETFs because of their index tracking objective, diversifying abilities, liquid access and transparency.

Sources: Reuters, iShares.com

 

Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise. A portion of the Fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Diversification may not protect against market risk.

 

Fund holdings are subject to change.

 

There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Although market makers will generally take advantage of differences between the NAV and the trading price of shares of an ETF  through arbitrage opportunities, there is no guarantee that they will do so.

 

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