Recent moves by The Vanguard Group highlight the increasing risks in the municipal bond sector. As a result of volatility in the municipal bond market, Vanguard has withdrawn documents it filed with the Securities and Exchange Commission (SEC) to launch three new municipal bond index funds and three municipal bond exchange-traded funds.
Late last year, there was a rush of new municipal bond issuance, as states and cities hurried to take advantage of the Build America Bonds program, which expired at the end of 2010. This program required the federal government to pay 35 percent of the interest costs on the bonds. The issuance led to an increase in supply of munis at a time when there was not a natural demand (due to economic conditions and precarious reports about municipal and state finances and fears of default) to absorb this increase in supply. As a result, the prices of munis have been falling, leading to the volatility that prompted Vanguard to shelve its plans to release the funds.
An index fund faces one of its most challenging periods when it is first launched. It is difficult for the fund to track the index because the amount of assets is still small. As the size of the fund increases, the fund more closely correlates with the index it is tracking. Now, with investors’ timidity about the markets, funds are seeing more outflows than inflows according to Morningstar, Inc. Additionally, twenty-five of the 30 muni bond ETFs were recently trading at a discount to their NAVs, according to IndexUniverse.com. Therefore the prospect of having the fund grow in size over the near term was limited. Chris Alwine, head of the muni bond group at Vanguard, told Investment News, that the company is waiting to see some stabilization in outflows and inflows before launching these funds.
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