Tax-Free Income And A Weekly Reset With This Muni ETF

The Federal Reserve could raise interest rates for the first time in 2016 next month, but one rate hike probably will not be enough to deter yield-seeking investors and some of their favored destinations, such as municipal bond exchange-traded funds.

The combination of interest rates remaining lower for longer and investors demanding more income and yield has been a driving force behind the resurgence of municipal bond ETFs this year.

The question savvy investors need to be considering right now is whether municipal bonds are inexpensive relative to other fixed income asset classes. Of course, investors worried about rate risk need to examine the duration, or sensitivity to changes in interest rates, of their municipal bond ETFs. Investors that are really skittish about this scenario can turn to variable rate funds.

An Ideal Muni ETF?

Said another way, the oft-overlooked PowerShares VRDO Tax-Free Weekly Portfolio PVI could be the ideal muni ETF for the current environment. PVI, which recently turned nine years old, holds a specific type of municipal bond that can prove effective in the face of rising rates.

“Variable rate demand obligation (VRDO) bonds that are exempt from federal income tax with interest rates that reset weekly, which comprise the Underlying Index,” according to PowerShares. “VRDOs are floating-rate bonds that provide investors with tax-exempt income. VRDOs are generally purchased at par. When they are put back to an investment dealer, the investor generally receives par plus accrued interest.” 

With a seven-day reset, duration is not an issue for PVI and its 37 holdings. The trade for lower duration usually means lower yields, and that is the case for PVI as the ETF sports a 30-day SEC yield of just 0.49 percent. On the other hand, PVI can also be used as a suitable alternative to money market funds.

“Money market fund reforms that took effect in mid-October have made VRDOs even more appealing, in my view. These reforms ­— designed to prevent a run on money market funds — have driven up short-term rates, as prime money market funds trade out of certificates of deposit (CDs) and commercial paper,” said PowerShares in a recent note.

Nearly all of PVI's holdings are rated A, AA or AAA. About 56 percent of the ETF's holdings have maturities ranging from five to 20 years.