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More Muni Bond ETFs on the Way

Barclays, State Street, ProShares and Van Eck all hope to cash in on early success of ETFs tracking other kinds of bonds.

Starting this week, investors can expect to see a slew of exchange-traded funds tracking municipal bonds, which are debt obligations issued by state or local governments, or government agencies.

They are coming to market after 24 ETFs tracking Treasurys and corporate bonds were launched this year, boosting total assets in bond ETFs to $26.78 billion as of July 31, compared with $18.17 billion a year earlier.

Like these other bond ETFs, the muni bond funds will help lower transaction costs, particularly for smaller investors. Bonds are traded only over the counter, making it difficult to know whether you're getting a fair price. You can end up paying as much as 2% in transaction costs on muni bond purchases.

It's not clear if the muni bond ETFs will gain as big of a following as the Treasury and corporate ETFs, however. Munis aren't as actively traded by big investors like hedge funds, and retail muni bond investors tend to use a buy-and-hold strategy. That means the ability to trade the muni ETFs throughout the day on an exchange may be less of a draw.

Barclays Global Investors was the first out of the gate Monday with the launch of the

iShares S&P National Municipal Bond Fund

(MUB) - Get Report

on the American Stock Exchange. Munis in the index it tracks must have a credit rating of at least triple-B-minus and have a minimum outstanding par amount of $50 million.

The fund will be rebalanced every month to match the index, although Barclays aims to keep turnover low to minimize capital gains. The annual expense ratio is 0.25%.

BGI also has filed plans for two additional ETFs that would invest exclusively in bonds issued by municipalities in either California or New York.

It won't be alone for long. Three other ETF sponsors have filed registration statements with the

Securities and Exchange Commission

to launch muni bond ETFs.

State Street Global Advisors, a unit of

State Street

(STT) - Get Report

, expects to launch the

SPDR Lehman Municipal Bond ETF

(TFI) - Get Report

later this week. This ETF will track the Lehman Brothers Municipal Managed Money Index, which provides exposure to more than 22,000 issues in the most liquid segment of the muni bond market. The securities in the index have an average credit quality of triple-A or double-A-one (depending on the credit rating agency).

In addition, none of the index's current constituents are subject to the alternative minimum tax. Most muni bonds are free from federal taxes, which is one of their primary draws. But investors who are subject to the AMT are required to pay taxes on income from muni bonds issued to fund certain kinds of projects.

State Street expects to charge an expense ratio of 0.2%.

The firm also has filed plans for three more ETFs based on

Lehman Brothers

TheStreet Recommends

(LEH)

indices tracking short-term munis, California munis and New York munis.

PowerShares hopes to launch four muni ETFs based on

Merrill Lynch

(MER)

indices by October. They will track insured nationals, higher-yielding uninsured nationals California and New York bonds.

Finally, Van Eck Global's Market Vectors unit also has filed plans for five muni bond funds based on Lehman indices tracking longer-dated maturities, shorter-dated maturities, high-yield California and New York munis.

Some of the ETFs launched this year tracking Treasurys indices have benefited from a flight to general quality amid concerns about the subprime mortgage crisis. The timing of the muni bond ETFs is less than perfect, however. As I wrote

here earlier this month, muni bonds have come under pressure lately from selling by hedge funds and heavy new issuance.

However, BGI, a unit of

Barclays

(BCS) - Get Report

, says clients have been asking for a muni bond ETF ever since it launched the first fixed income ETFs in 2002.

"With more than 1 million individual securities from more than 50,000 distinct issuers, the muni bond market is very large and fragmented," says Matthew Tucker, BGI's head of fixed income investment solutions. "We looked to find an index that represents the liquid part of the market."

While the fund's benchmark index is composed of more than 3,000 bonds, it will hold just 25. Tucker says this could result in a long-term tracking error, or deviation from the index, of 0.5% to 0.75%.

Matt Fabian, senior analyst at Municipal Market Advisors, an independent research firm, says that level of tracking error seems "reasonable" considering the limitations of the muni market. "Launching in the ETF space will be difficult because the underlying bonds are difficult to procure. A lot of these bonds go into investor portfolios and are never traded again."

It remains to be seen whether the potential market is big enough to sustain four families of muni bond ETFs. But the new iShares fund may have something of a first-mover advantage, because traders typically jump into the first ETF in a particular sector, allowing it to accumulate assets and develop liquidity relatively quickly. That's an important consideration for investors, because many ETFs of all different stripes launched this year have failed to attract much of a following.

The fund also should benefit from Barclays' tremendous marketing muscle.

However, Paul Mazzilli, Morgan Stanley's director of ETF research, says getting to market first may not be as big of an advantage for muni bond ETFs as it has been for other kinds of funds. "There is more of a first-to-market advantage when there is pent-up demand," he says.

"When the

streetTracks Gold Shares

(GLD) - Get Report

came out, there wasn't an easy way to (invest in) gold. The same with silver and international real estate. But I'm not sure you have the same pent-up demand here. Investors have many ways to get muni bonds, from buying them outright to closed-end funds that offer higher yields than the ETFs and that you can buy at a discount."

And Mazzilli thinks that, unlike ETFs that track gold or oil, muni bond ETFs are unlikely to be popular with traders and hedge funds.

"It's hard to see traditional muni investors buying this," adds Fabian of Municipal Market Advisors. "I think that direct ownership is more efficient for most buyers because you buy it outright and don't have to pay ongoing management fees. Most people just want the income and don't care about diversification."