After taking a tumble last year, municipal bond ETFs are once again ready to carve their spot in investor portfolios alongside tax-exempt individual bonds and mutual funds. But as they regain their footing, they face a number of obstacles, including efforts in Washington to limit or revoke the tax-exempt status of municipal bond interest, as well as financial advisors who question the need for another investment option in this vast universe covering some $3 trillion in securities.

Municipal bond ETFs got a late start in 2007 with the launch of the first municipal bond ETF, the iShares S&P National Municipal Bond Fund (MUB). Since then these products, which hold some $9 billion in assets, have survived two significant corrections. The first happened in 2008 after the Lehman Brothers collapse sent bonds and other securities plummeting.

The second occurred a little over a year ago when Wall Street analyst Meredith Whitney predicted that with state and local governments scrambling for revenue, the municipal market would see 50 to 100 large defaults in 2011 totaling hundreds of billions of dollars. That dire warning, which far exceeded the record of $8.2 billion in defaults for 2008, sent shivers through the market.

Despite Whitney's prediction, municipal defaults for 2011 were far less than the $2.4 billion that defaulted the previous year, and municipal bonds returned to favor as attractive yields and a more stable outlook drew investors.

While there's been talk in Washington of limiting the tax-free status of municipal bonds, some observers believe the market is back on track, at least for now. "With 2012 being an election year, it would be politically unwise for legislators to slip into a discussion that would threaten the municipal market," says Jim Colby, senior municipal strategist and portfolio manager at Van Eck Global, sponsor of the Market Vectors ETFs. "With all the efforts over the years to target municipals to cut deficits, this remains a healthy, thriving market."

Municipal finances are also stabilizing, according to the Rockefeller Institute, which found that 46 states posted annual revenue increases averaging 8.4% in 2011, the largest gain since 2005. "This, along with continued spending restraint, has improved the fundamental credit outlook for municipals, though headline risks remain, particularly related to the high-profile distress stories in Harrisburg, Pennsylvania; Jefferson County, Alabama; and Central Falls, Rhode Island," notes a report from BlackRock.

Even if the market for municipal bonds remains healthy, the ETFs face the challenge of quirky pricing issues unique to the municipal market. Unlike most stocks and Treasurys, municipal bond trades are handled through a vast over-the-counter dealer market that shepherds more than 55,000 different issuers. Dominated by large buy-and-hold institutional investors, the fragmented market is much less liquid than most other corners of the investment universe, with most issues trading infrequently.

ETFs have some advantages over both mutual funds and individual bonds. Although the latter have a specific maturity date that conservative investors crave, the illiquidity of the muni market means transaction costs can easily run 1.5% on either side of a trade for a $25,000 block of bonds. And as municipalities continue to struggle with finances, the risk of a credit downgrade makes individual securities vulnerable to losses.

By contrast, municipal bond mutual funds offer the benefits of diversification, active management and liquidity. But average expenses of 1.05% a year eat into returns.

Municipal bond ETFs, which include hundreds of issuers and have typical expense ratios of 20 to 30 basis points, answer the need for diversification and liquidity and leave more money on the table for investors. But during times of high market volatility, such as the end of 2010, the net asset value and market value of the securities can drift apart.

"The issue I have with these ETFs is the periodic risk of market price deviation from net asset values," says Marvin Appel of Appel Asset Management in Great Neck, N.Y. "That's one reason I prefer buying individual bonds and holding them to maturity in the investment-grade area, and using mutual funds for lower-quality, higher-yielding bonds." 

Colby counters that the market price of the ETFs is "a fair representation of value. And there have only been a few short periods in the last four years when these unusual pricing discrepancies have occurred."

Matt Tucker, head of fixed-income strategies for iShares, believes that the occasional large gaps between net asset value and market price with muni ETFs are simply a function of ETF transparency that provides a more real-time view of what goes on in mutual funds anyway. "ETFs are a window that lets people see the way the municipal market trades," he says.

Another concern is the market-weighted structure of the indexes, which often results in large bond positions in California and New York, two of the most fiscally strapped states in the country. Without the constraints of market weighting, actively managed mutual funds have the flexibility to spread money across a broader range of locations.

Despite issues such as this, managers see evidence that diversification, transparency, low costs and high yields continue to draw investors to this fund group. Assets in Van Eck's municipal bond ETFs grew from $500 million at the beginning of 2011 to $825 million by the end of the year. Much of that growth was from new money coming into the funds, says Colby.

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