Investors seeking diversity, liquidity and competitive yields when compared to other fixed-income products are trying a relatively new alternative: municipal bond exchange-traded funds.

Portfolio managers and analysts say ETFs — which trade in real time and track market indexes — have seen solid price performance in recent months. At the same time, assets have held steady in the face of credit concerns about the municipal bond market in general.

“A lot of the gains did occur in the third quarter with cash coming in and valuations going higher,” said Jim Colby, senior municipal strategist and portfolio manager at Van Eck Global in New York City, which offers five municipal ETFs representing $800 million of assets under management as of Oct. 31.

The muni ETF industry was launched in late 2007 and grew steadily to about $7.7 billion in assets as of October 2010, according to figures provided by Lipper, a Thomson Reuters Co. But as 2010 drew to a close investors spooked by media reports predicting a surge in bond defaults began pulling money from muni bond funds. Nevertheless, as of the end of October 2011, municipal ETF assets were back to about $7.6 billion.

While muni ETFs remain a small slice of the $492 billion municipal fund industry, managers say the proof of their increasing popularity is seen in recent steady demand and growth of assets.

Colby said the Van Eck High Yield Muni ETF, for instance, swelled to $285 million as of Nov. 9, compared to $175 million at the start of 2011.

The fund, which has a 9.48-year duration and an average credit quality of double-B, posted a 30-day yield of 6%, as of Nov. 3, and year-to-date total return of 7.65%, according to data from Morningstar, Bloomberg and Van Eck that was compiled by the asset manager.

The fund also posted a taxable equivalent yield of 9.23% for an individual in the 35% tax bracket, as of Oct. 31, according to data provided by Van Eck.

Dividends from muni ETFs are exempt from federal income taxes, but typically are subject to state income taxes.

New York residents can invest in one of the two New York muni ETFs, with the dividends exempt from state income taxes. There are two California state-specific municipal ETFs.

The Van Eck Intermediate ETF, meanwhile, rose to $305 million, up from $209 million at the start of the year. The fund posted an 8.58% year-to-date total return and a 30-day yield of 3.04%, as of Nov. 3. It has a duration of 6.44 years and an average credit quality of double-A.

In addition, the Van Eck Short-Term ETF has increased to $113 million from $102 million in January. With a 1.30% 30-day yield, and a year-to-date total return of 3.40%, the fund has an average credit quality of double-A and a duration of 3.26 years.

“Individuals are bar-belling their risk to achieve better income and anchor their investment portfolios,” Colby explained.

The consistent net inflows this year for muni exchange-traded funds are viewed as positive in the face of the more than $19 billion of outflows that have hit municipal mutual funds for the year to date, observed Matt Tucker, head of fixed-income strategy for iShares, citing figures from the Investment Company Institute that were compiled by iShares’ parent company BlackRock Inc.

iShares offers 10 municipal ETFs with a total of $3.2 billion in assets under management, including the iShares S&P National Municipal Bond Fund — the largest and oldest ETF with over 1,500 positions and now sized at $2.3 billion. It was launched in September 2007.

Tucker said traditional mutual fund and individual bond investors are moving toward muni ETFs as a new way to access the market.

The keen focus on credit risk  in the last 12 months has been a key driver of demand for the funds recently, he said.

“As a result of the financial crisis, and the demise of bond insurance, investors have rightfully become much more concerned about credit risks in the muni bond market,” Tucker explained.

“The heightened credit risk in 2010 triggered redemptions at the end of 2010 and into 2011.”

But the scenario improved by the third quarter, and cash started flowing into muni ETFs, managers noted.

“The rebalancing and refocus that occurred, plus the flat-out attractiveness of municipals versus other fixed-income asset classes — whether on a taxable-equivalent or after-tax basis — gave advisors an opportunity to sell the product again,” Colby said. “We went from the end of December 2010 into January 2011 with the words of Meredith Whitney ringing in our ears that the country wasn’t coming out of a recession, and everything pointed to a mediocre year for munis.”

Whitney, a financial analyst, rocked the muni market late last year with her on-air prediction that 2011 would see massive municipal defaults.

That hasn’t happened, and the iShares muni ETF family saw $237 million of new flows year to date, according to Tucker. He believes that figure paints a rosy picture given the heavy mutual fund outflows seen earlier this year and the changing landscape of the muni market in general.

“It’s a more challenging environment,” he said. “In a market where there are a lot of headlines, investors want to know what type of bonds they are holding.”

Safety-conscious investors are gravitating toward muni ETFs for their diversity, as well as the heightened transparency and real-time trading — important characteristics in a market that is drastically different compared to just five years ago, managers said.

Back in 2006, when roughly 70% of the municipal universe was triple-A-rated and many bonds were insured, “investors didn’t have to worry about credit quality that much,” Tucker noted.

“We are in a very low-rate environment right now where investors are focused on net yields inclusive of all fees and expenses,” he said.

Currently, the iShares national fund charges a 25 basis-point fee and has a 30-day yield of 2.73%, as of Nov. 3. It also has an average credit quality of single-A, has a duration of 7.08 years and posted a 4.20% taxable-equivalent yield, as of Oct. 31.

On Monday, generic, A-rated general obligation bonds due in 2018 yielded a 2.53%, according to Municipal Market Data, which equates to a taxable equivalent yield of 3.89% for an individual in the 35% tax bracket.

Van Eck’s Colby said that overall spreads on muni ETFs have been favorable in general, adding that they’re “not two pennies, but it’s not two points either.”

“The price volatility of ETFs is right in line with most all other municipal products — we are not more volatile and the market-makers have come to find these products to be efficient and liquid.”

The Van Eck long ETF fund posted a 30-day yield of 4.36%, as of Oct. 31. That compares to the Franklin Federal Tax-Free Bond Fund, which posted a 3.55% yield, and the Eaton Vance AMT-Free Municipal Income Fund, which posted a 4.47% yield for the same period.

The fund, which tracks the Barclays Capital AMT-Free Long Continuous Municipal Index, has a management fee of 24 basis points and has thrived, achieving a year to date total return of 12.26%. It also has a duration of 11.56 years and an average credit quality of A.

“The ETF structure is delivering very competitive yields and in some cases we are better than some open-ended products,” Colby said, referring to open-end mutual funds. “We are doing what we set out to do and deliver yield in a representative part of the curve that is competitive.”

Exchange-traded funds have similar risks to other fixed-income fund products, such as changes in share price due to fluctuations in interest rates. ETFs, like other fund products, offer an easy way to diversify.

“As a traditional individual bond investor, you can see the bonds you hold, but diversification can be a problem,” Tucker said.

He added that those who buy individual bonds also can have difficulty building a diversified portfolio without a large amount of money to invest and because of the high bid-offered spreads, which in some cases can be in excess of 100 or 200 basis points.

ETFs are also flexible in terms of trading options, Tucker pointed out.

Mutual fund “investors can only transact at the end of the trading day, and with ETFs, investors can execute in real time, like a [listed] stock” since the funds trade on either the AMEX, NYSE or Nasdaq, he said.

With new issue supply scarce in the first half of 2011, ETFs helped provide a large amount of readily-available bond positions in one basket. “It’s been hard to efficiently buy and sell municipal bonds, so this gives investors a vehicle to do that,” Tucker said.

Colby said Van Eck tries to minimize duration risk by capturing roughly 90% of the yield of the intermediate sector by focusing on the six- to 16-year range while competitors are often typically active in the five- to 10-year slope.

“For individuals who make a commitment in a very uncertain interest-rate environment they are getting compensated for it,” Colby said.

Colby said Van Eck aims to both minimize and capitalize on credit risk in its high-yield ETF by owning bonds from across the investment-grade spectrum from triple-B to triple-A.

“We are trying to find bonds that are not overly sensitive to the marketplace and that respond properly when markets change,” Colby said. “We built these ETFs to represent risk, but to deliver as much yield to the client as possible.”

-- This article first appeared on The Bond Buyer.



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