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.

Tucker points out that while municipal bond mutual funds saw outflows in 2011, municipal bond ETFs took in some $700 million in new money. "In an uncertain credit environment, investors want to see what they're holding. They want diversification. And they want intra-day liquidity. Municipal bond ETFs offer all of those things."

Weighing The Options

For those considering municipal ETFs, available options cover a wide variety of durations, credit qualities and geographic locations.

At $2.4 billion in assets, the iShares National Municipal Bond Fund is by far the largest member of the group. The fund, which has a 0.25% expense ratio and a seven-year duration, is spread across some 1,500 holdings. At 40% of assets, California and New York state issuers dominate. The $1 billion SPDR Nuveen Barclays Capital Municipal Bond ETF (TFI) has a slightly longer nine-year duration, a 0.23% expense ratio and a 30% weighting in New York and California bonds. Both funds have posted similar total returns over the last three years.

The $1.4 billion SPDR Nuveen Barclays Short-Term Municipal Bond ETF fund (SHM) appeals to investors looking for a shorter-term option. Its duration is just shy of three years, and it has a 30-day SEC yield of 0.80%.

With interest rates falling over the last three years, longer-term bonds have been the most profitable area of the fixed-income market, and munis are no exception. Fans of a belt-and-suspenders approach have gravitated to the PowerShares Insured National Municipal Bond Portfolio (PZA), which has collected more than $550 million since its introduction four years ago. Most of the 175 bonds in the portfolio are rated "AA" by Standard & Poor's. The portfolio has a duration of 12 years and a recent yield of 4.13%. Another long-term muni ETF, the Market Vectors Long Municipal Index fund (MLN), has a 30-day SEC yield of 4.3%, which translates into a taxable equivalent yield of 6.63% for someone in the 35% federal tax bracket.

In the high-yield space, the Market Vectors High Yield Municipal fund (HYD) sports a yield of 5.77%, representing a taxable equivalent yield of 8.9% for someone in the 35% federal tax bracket. Based on the Barclays Capital Municipal Custom High Yield Composite Index, the fund tracks the high-yield municipal bond market with a 75% weight in non-investment-grade municipal bonds and a 25% weight in "Baa"/"BBB"-rated bonds, the lowest investment grade. At the other end of the safety spectrum, the firm's Pre-Refunded Municipal fund (PRB) invests in municipal securities secured by Treasurys held in an escrow account. Because of the airtight guarantee of repayment and low risk, the yield on the offering is a modest 0.56%.

Other offerings focus on taxable municipal securities issued under the Build America Bond program as a way to lower borrowing costs for state and local governments. Three such funds are the PowerShares Build America Bond Portfolio fund (BAB), the SPDR Nuveen Build America Bond fund (BABS) and the PIMCO Build America Bond Strategy fund (BABZ). With yields of about 5%, these portfolios consist mainly of securities rated "A" or better by Standard & Poor's.

In a new twist, target-dated municipal bond ETFs from iShares offer both the diversification of a bond fund and a known maturity date. The goal is for ETF holders to get monthly income during the life of the fund and a return of their original investment when the bonds mature in a specified year from 2012 to 2017. The firm has filed two new ETFs with the SEC that mature in 2018 and 2019.