Competitive yields make muni ETFs attractive

Exchange traded funds that invest in municipal bonds are looking more attractive these days, thanks mostly to their competitive yields. For example, on Feb. 1, 10-year U.S. Treasury bonds were yielding 3.62%. The Market Vectors Lehman Brothers AMT-Free Intermediate Municipal Index ETF, offered by Van Eck Associates Corp. of New York, was yielding 3.49%. It targets the 6- to 16-year part of the yield curve. However, because the yield paid out by muni ETFs is free of federal taxation, the effective income is greater than the taxable yield currently offered by Treasuries, which means that assuming the highest federal individual income tax rate of 35%, the Van Eck ETF offered a tax-equivalent yield of 5.38%. The story is similar with comparable muni ETFs. The iShares S&P National Municipal Bond Fund, from Barclays Global Investors of San Francisco, had a yield of 3.44%, but the tax equivalent yield was 5.07%. The SPDR Lehman Municipal Bond ETF, from State Street Global Advisors of Boston, had a yield of 3.34%, but the tax equivalent yield was 5.14%. Given such numbers, some investors might want to consider muni ETFs as an alternative to Treasuries, said James Colby, Van Eck's senior municipal strategist. "They are a terrific bridge strategy for those that are uncertain about what's going on in the Treasury markets," he said. "What's wrong with a strategy that puts you in a position to earn some tax-free income while you determine how to adjust your portfolio?" Some financial advisers said they don't see anything wrong with such a strategy.
It appears that interest rates may continue to fall, said Tom Lydon, president of Global Trends Investments, a Newport Beach, Calif.-based firm with $70 million under management. In such an environment, investors looking for a little extra yield may do well to consider muni ETFs, he said. "The environment [for muni ETFs] looks safe," Mr. Lydon said. Some particularly savvy invest-ors have already picked up on the potential muni ETFs may hold, said Richard Romey, president of ETF Portfolio Solutions Inc., an Overland Park, Kan.-based firm with over $30 million under management. "I have had several clients ask me what I thought about muni ETFs," he said. So far, Mr. Romey hasn't found anything not to like. They are generally less expensive than mutual funds that invest in municipal bonds, he said. For example, the Market Vectors Lehman Brothers AMT-Free Intermediate Municipal Index ETF and the SPDR Lehman Municipal Bond ETF have expense ratios of 0.2%. The expense ratio of the iShares S&P National Municipal Bond Fund is 0.3%. That's cheaper than most mutual funds that invest in munis, with the exception of the muni bond funds offered by The Vanguard Group Inc. of Malvern, Pa. which offers such funds with expense ratios as low as 0.09%.

BEST ROUTE?

For investors looking for a true representation of the muni market, muni ETFs may be the best way to go, Mr. Romey said. He hasn't used any yet, but Mr. Romey said that may change soon, since the first such ETFs didn't come out until September. Muni ETFs may be a good addition to many portfolios, but because they and their indexes are so new, it may make sense to wait a bit longer before buying them, said Sonya Morris, editor of Morningstar ETF-Investor, a newsletter published by Morningstar Inc. of Chicago. For years, it was thought that the muni market was too opaque for there to be muni indexes, she said. The indexes upon which the muni ETFs are built may work just fine, but Ms. Morris would like to take some time to see whether they end up trading at premiums or discounts to their net asset value. Despite all the perks muni ETFs have to offer, Jeff Ptak, Morning-star's director of exchange-traded securities analysis, cautioned against investing in muni ETFs just for the yield. "Generally speaking, stretching for yield tends to be a dangerous game," he said. "What we have tended to see is that is injurious to investors' total return." David Hoffman can be reached at dhoffman@crain.com.