Money Market ETF Not as Safe as it Appears

PowerShares' new fund tracks an index of variable-rate demand notes, long-term bonds that act like short-term notes.
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Updated from Nov. 21.

PowerShares

has come out with an exchange-traded fund designed to act like a tax-free money market fund, but it's not quite the low-risk investment it appears to be.

The

VRDO Tax-Free Weekly Portfolio

(PVI) - Get Report

tracks the performance of a pool of variable-rate demand obligations, or VRDOs, which are long-term, fixed-rate municipal bonds that act like short-term floating-rate notes.

They are popular with money market funds because they yield slightly more than some other short-term instruments, like Treasury bills and certificates of deposit, and have widely been perceived as safe.

VRDOs act like money market instruments because investors can demand repayment at par with seven days' notice. Also, the interest rate on the notes is reset each week at prevailing money market rates. This interest, which is paid out on a monthly basis as dividends, is exempt from federal tax. Depending on where you live, it may also be exempt from state tax.

In the past, they have been considered relatively safe because many of the municipal bonds are insured, and the issuers' ability to repurchase them is typically also guaranteed by a letter of credit from a bank.

PowerShares says PVI pays about 3.5% pretax, which would equate to a 5% after-tax yield. The ETF tracks the Thomson Municipal Market Data VRDO Index and charges an annual expense ratio of 0.25%.

PowerShares expects PVI will have a lot of appeal with institutional investors as place to park money for short periods of time and earn tax-free interest. "It's weekly paper with guaranteed principal," says John Southard, a managing director. "It's not risky at all."

(The Securities and Exchange Commission has since asked for clarification as no investment is risk-free. "Obviously, I didn't mean it has no risk," says Southard. "I meant compared to other investments, it's lower risk.")

Typically, that's true. But these are not typical times for municipal bonds or the broader credit markets. "VR" could stand for "very risky" with all the trouble brewing.

The subprime mortgage crisis and credit crunch have spilled into the $2.5 trillion muni bond market. Munis swooned in August when some troubled hedge funds dumped them to raise cash. They recovered some of the lost ground in September and October as the credit markets stabilized, but over the past few weeks, there have been fresh signs of trouble.

This time the fear is that companies like

Ambac Financial Group

(ABK)

and

MBIA

(MBI) - Get Report

that insure muni bonds will run into trouble. These same companies also insure securities backed by subprime mortgages, and as more of these loans go bad, the insurers are being called on to cover missed interest and principal payments.

"The floating-rate market in munis is in turmoil," says Matt Fabian, senior analyst at Municipal Market Advisors, an independent research and strategy firm. "There is a lot of concern about the bond insurers in VRDOs.

Fitch Ratings has already raised questions about the cash reserves of several bond insurers. If the insurers are downgraded and lose their triple-A ratings, the muni bonds they insure would lose some value. "In the near-term, trading and liquidity would likely be disrupted," says Fabian. He says that might induce holders of VRDOs to demand repayment, depleting the cash reserves of the banks that provide liquidity.

"It appears to be very poor timing for the ETF because of all the concerns about the big bond insurers," says Peter Crane, president and publisher of Crane Data and Money Fund Intelligence.

He notes that the subprime mortgage crisis has made investors extremely averse to complex instruments such as the securities backed by mortgages. "And anything with 'variable' in the name means structure, complex or both," he says, referring to VRDOs.

VRDO investors are by nature cautious, so any market disruption would likely be compounded by the number heading for the exits. "Currently tax-free and municipal money market mutual funds hold 75% of their assets in rated demand notes," says Connie Bugbee, managing editor of Imoney.net. "I would hate to say they are no longer safe."

Safe or not, now might not be the best time to buy the VRDO ETF.