Take Caution

 | Mar 28, 2012 | 1:00 PM EDT
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This article originally appeared earlier today on ETF Profits.

Muni bonds have always been popular investment destinations, and it should come as no surprise that a number of exchange-traded products offering access to this asset class have emerged in recent years. Because the interest generated from these securities is exempt from most income taxes, muni bonds are capable of delivering significant tax equivalent yields to investors. That feature has made them popular with investors looking to access an asset class that has historically been relatively low risk.

But, taking a closer look at many of the most popular muni bond ETFs reveals a meaningful tilt toward the low end of the creditworthiness spectrum. Many of these funds load up on debt from the cash-strapped states that could have some troubles servicing their debt obligations.

iShares S&P National Municipal (MUB) has close to $3 billion in debt. California accounts for about 23% of the fund, followed by New York with 18%. These states have some of the lowest credit ratings and largest budget deficits, indicating that they could encounter challenges in the future when collecting on that debt. The states that maintain AAA credit ratings make up a relatively small portion of MUB and other muni bond ETFs.

California's fiscal mess will take nothing short of a miracle to clean up. The state is running at a massive budget deficit, and plans to increase spending dramatically over the next several years. Some pretty hefty tax hikes are in the works, as well, which bodes well for investors in muni debt. However, the vulnerability to a downturn in the market remains a huge threat to the state's budget.

New York and Illinois are in similar positions and appear to be running out of ways to raise revenue. They are struggling to follow through on proposed cuts to costly programs. Meredith Whitney's prediction for a muni bond doomsday may not have come to fruition, but it's hard to argue against significant risks remaining in the muni market -- especially when exposure is concentrated in the states with the biggest fiscal crises on their hands.

This issue is in a sense indicative of a larger problem with combining indexing strategies and fixed income: a tendency to overweight the largest debtors. Because California has the most municipal debt outstanding, which explains its current position between a rock and a very hard place, it gets a huge weighting in funds like MUB. States that have their fiscal houses in order have relatively small weightings because they have relatively little debt outstanding.

As a side note, this indicates that some room exists for ETF issuers to expand the product offerings in this corner of the fixed-income market. I'd be interested in a muni bond that focuses only on debt from issuers in states that maintain AAA credit ratings or only on debt of states that have no state income tax -- that hypothetical fund would be dominated by bonds from Texas and Florida.

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