0The exponential growth of exchange traded funds (ETFs) in recent years has resulted in a plethora of ETF offerings in virtually every sector and asset class, and municipal bonds have been no exception. These versatile instruments have become popular with investors in higher tax brackets and fill a specific niche in the wide selection of fixed-income offerings that are now available. Many fixed-income investors who sought tax-free interest in the past through individual municipal securities will find municipal ETFs to be attractive alternatives in several respects.

What Are Municipal Bond ETFs?
Like any other exchange traded fund, a municipal bond ETF is simply a collection of individual municipal debt securities that have been selected by professional portfolio managers and bundled into a packaged fund that trades on one or more of the major stock exchanges. Municipal bonds are debt securities that have been issued by municipalities, such as towns and cities, in order to raise capital.

All municipal bonds issued today fall into one of two basic categories. Revenue bonds are issued to pay for projects such as sports stadiums and complexes, toll roads and bridges and other facilities that generate revenue. General obligation bonds are used to pay for other necessary municipal services and projects, and are backed by the taxing power and authority of the issuer.

Municipal bond ETFs are often structured to mirror an index that is made up of muni offerings. Some funds instead invest in a selection of municipal offerings that meet certain criteria such as a minimum financial rating (i.e., AA or better), revenue versus GO, exemption from being a preference item for AMT (see below) or high-yield offerings. As with stocks or other individual securities that are publicly traded, municipal bond ETFs can be bought and sold in intraday trading whenever the markets are open.

Advantages of Municipal Bond ETFs
Municipal bond ETFs offer several advantages over both individual muni securities and traditional open-end municipal bond funds that are actively managed. Like traditional funds, municipal bonds ETFs offer diversification with a selection of securities that have been picked by professional portfolio managers (if the fund is not an index fund that simply mirrors the securities in an index). However, these instruments are also much more liquid than their traditional counterparts because they can be bought and sold during market hours without having to wait for several business days.

Their transaction costs are also often substantially less, as they have no front or back-end sales charges and have very low management fees. They also offer stable income with a very limited amount of risk; since 1970, the number of municipalities that have defaulted on their obligations totals less than one-tenth of one percent of the total number of offerings issued.

Analysts group municipal bonds as being second only to government bonds in terms of safety, and many of these offerings also carry additional insurance to protect against default. Furthermore, the interest that is generated by municipal bonds is tax-free at the federal level to the investor, which makes them attractive to wealthy and high-income investors.However, the IRS has revealed that over half of the total amount of municipal bond interest was paid to taxpayers with incomes of less than $200,000.

Municipal bonds are also exempt from both state and local taxes for investors who live in the same state or city as the issuer in most cases. Municipal bond interest has become even more attractive to investors since the resolution of the fiscal cliff issue, because the tax rates on other types of investment income such as dividends and capital gains are now higher.

Disadvantages of Municipal Bond ETFs
The biggest drawback to investing in municipal bond ETFs is the low rate of interest that most of them pay. Municipal bond interest is lower than taxable interest, such as that paid from CDs or corporate bonds, because it is tax-free. The taxable-equivalent yield of this interest must be calculated in many cases in order to determine whether it is better to invest in a municipal bond or ETF than a taxable offering.

Investors who purchase municipal bonds from issuers located outside their state or municipality will also have to pay state and possibly local tax in the interest they receive. Furthermore, municipal bond interest is one of the preference items for the Alternative Minimum Tax (AMT), which means that investors who receive more than a certain amount of this type of interest may have to pay tax on some or all of it, depending upon various factors.

Also, while the individual securities that comprise municipal ETFs are usually guaranteed by the issuer, the share prices of municipal ETFs fluctuate according to supply and demand and other forces in the markets because they trade in a secondary market. Factors such as changes in interest rates may result in capital losses for some investors.

Who Should Invest in Municipal Bond ETFs?
Investors who are seeking tax-free income of any kind should look carefully at municipal bond ETFs for their liquidity, diversity and relative safety. They can be appropriate for both long and short-term investors, but those who intend to trade these instruments heavily need to keep an eye on the cost of their transactions. But municipal bond ETFs can provide greater tax-equivalent interest than other types of guaranteed instruments such as CDs or treasury securities with very little risk, so they are ideal for those seeking income from conservative sources.

The Bottom Line
The survival of the tax status of municipal bond interest through the fiscal cliff resolution will most likely lead to increased interest in these instruments from both large and small investors. States that are strapped for cash are also paying higher interest on their bonds that states that are in better financial condition, so investors who are willing to pay state income tax on their offerings would be wise to shop around a bit. For more information on municipal bond ETFs, consult your broker or financial advisor.

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