Van Eck introduced the Market Vectors CEF Municipal Income ETF (XMPT) on Wednesday, giving investors another option for accessing a corner of the U.S. bond market that has been the subject of heated debate in recent weeks. The new ETF will seek to replicate the S-Network Municipal Bond Closed End Fund Index, a benchmark that includes U.S. CEFs that are designed to produce federally tax-exempt annual yield. Currently, the underlying index consists of about 88 closed end funds. Almost 95% of the underlying index is investment grade debt.
Closed end funds are investment companies that trade throughout the day like stocks and ETFs. Unlike exchange-traded products, however, CEFs don’t feature the same creation/redemption mechanism that keeps prices consistently in line with the net asset value (NAV) of the underlying holdings. As such, CEFs often trade at a discount or premium to NAV, introducing additional risk factors but also allowing investors to potentially realize higher yields when a disconnect exists between the NAV and market price. The underlying index methodology gives a greater weight to CEFs trading at a discount, potentially beefing up current returns realized when distributions are made [see Three Bond ETFs With Juicy Yields].
There are a number of different kinds of CEFs. About half of the market is muni bond funds, but there are also products focusing on equities, taxable bonds, and option writing strategies. Some closed end funds issue preferred stock or debentures or borrow money in order to leverage their positions, which allows them to utilize the proceeds to invest in additional securities deemed to be attractively priced. The use of leverage creates an opportunity to further enhance yields; because muni bond CEFs are able to borrow at tax exempt short term rates, investing the proceeds of those borrowings in further bonds translates into greater distributions received. Leverage also obviously can increase the volatility of a fund; increases in interest rates may have a greater impact on a leveraged CEF than an otherwise similar unleveraged fund.
About 85% of the XMPT portfolio consists of leveraged investment grade CEFs, while another 4% or so is leveraged high yield CEFs.
|12 Month Distribution Yield||6.71%|
|Average Modified Duration||10.35|
|Average Weighted Leverage||33.70%|
|Number of Issues||88|
|As of 6/30/2011. Data is for index.|
XMPT contains elements of both active and passive management; the product seeks to passively replicate an index comprised of actively-managed CEFs. The benchmark to which XMPT is linked determines weights to individual funds based on net assets, as opposed to market capitalization. That nuance will avoid overweighting funds trading at a premium to NAV, avoiding a potential inefficiency in cap-weighted CEF indexes. XMPT will also effectively shift assets from funds trading at a premium to those trading at a discount at quarterly rebalancings [see Cap Weighting Loses Again].
To further tilt the portfolio toward funds at a discount, an adjusted net assets figure is used in XMPT’s index. CEFs trading at a discount of 6% or more get a 30% increase in net assets for purposes of calculating index weight. Those with a discount between 3% and 6% get a 20% bump, and those at a discount of 3% or less get a 10% bump. Similar reductions are made to the net asset figure used to calculate the weight of CEFs trading at a premium.
XMPT isn’t the first ETF to offer exposure to closed-end funds. Last year PowerShares debuted the CEF Income Composite Portfolio (PCEF), which offers exposure to taxable investment grade and junk bonds as well as those that utilize an equity option writing strategy. Similar to the new Van Eck fund, PCEF uses a methodology designed to shift holdings towards CEFs trading at a significant discount to their NAV. PCEF has assets of about $250 million, and charges total annual fees (including acquired fund fees and expenses) of 1.62%.
One noteworthy element of the new ETF is a relatively steep expense ratio; XMPT will feature a gross expense ratio of 1.57% and a net ER of 1.43%, making it the most expensive option in the National Munis ETFdb Category. That hefty price tag is attributable in part to the nature of the underlying holdings; because XMPT invests in closed-end funds, investors are effectively paying two layers of management fees to access the municipal bonds held by the CEFs that make up XMPT. It should also be noted that the use of leverage by the underlying CEFs has an impact on the bottom line expense ratio of the ETF. CEFs are required to support interest expense as part their total expenses, which flows through to XMPT’s total fees.
Muni Bonds In Focus
XMPT is the 24th ETF in the National Munis ETFdb Category (there are separate categories for California and New York munis). Van Eck already offers several targeted muni bond ETFs, including funds focusing on debt of various durations (ITM, SMB, MLN), a high yield muni bond ETF (HYD), and a pre-refunded muni bond ETF (PRB).
Municipal bonds have been on a wild ride over the course of the last several months, as different groups of investors have taken on opposing viewpoints as to the outlook for this asset class. Some of the more bearish predictions have included waves of defaults as state and local governments struggle to make good on their obligations, a scenario that could hammer values and increase the cost of borrowing. As that anxiety has built, the yields on many muni bond ETFs have climbed, creating potentially attractive yields if default rates stay in line with historical averages [see Five ETFs To Watch If Meredith Whitney Is Right].
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Disclosure: No positions at time of writing.