Invesco PowerShares plans to launch its second exchange-traded fund devoted to Build America Bonds, highlighting both the proliferation of municipal ETFs and the growing importance of taxable state and local government debt.
Invesco earlier this month filed a prospectus with the Securities and Exchange Commission to launch the PowerShares Intermediate Build America Bond Portfolio, which is designed to track the BofA Merrill Lynch 1-12 Year Build America Bond Index.
The new venture represents the third BAB ETF and at least the 29th municipal ETF.
Invesco PowerShares runs five muni ETFs and is part of Invesco Ltd., the Atlanta-based fund manager.
It launched the first BAB ETF in November, the PowerShares Build America Bond Portfolio.
ETFs typically seek to mime the performance of an underlying index, offering investors passive exposure to a given sector or strategy.
Most are much smaller than the indexes they seek to replicate.
The first Invesco PowerShares BAB fund, for instance, owns just 209 bonds worth $350 million. The index it tries to shadow tracks 5,650 bonds worth $104 billion.
To accomplish the goal of using a small portfolio of bonds to replicate a big index, ETFs employ a strategy known as representative sampling.
This entails breaking down the securities in the index by factors such as duration, maturity, credit quality, and yield. The manager then populates the fund with bonds that in aggregate share the risk characteristics of the overall index.
The latest ETF seeks a correlation of 0.95 with its index, meaning an increase in the index value will translate to an almost one-for-one expansion in fund assets.
The upcoming ETF is similar in most respects to the existing Invesco PowerShares BAB fund.
Both will invest mainly in BABs, pay monthly dividends, and be managed by Peter Hubbard.
The difference is that the original BAB ETF seeks to replicate the returns of the Bank of America Merrill Lynch index following the overall BAB sector.
The intermediate fund’s index follows only BABs with maturities of 12 years or less. At $10.8 billion, these are a fairly small portion of the $110 billion BAB sector.
Many BABs are issued with maturities of 20 or 30 years.
By launching a fund with a maturity specification, Invesco PowerShares will offer investors the opportunity to gain exposure not only to the BAB sector, but to BABs with particular levels of interest-rate risk.
The effective duration — or the magnitude by which price would change for a given shift in interest rates — is 6.9 for the Bank of America Merrill intermediate index. The duration of the broader index is 11.1.
With less interest-rate risk comes lower yields.
The average yield on the intermediate index is 4.28%, 140 basis points lower than the yield on the broader index.
Invesco is not the first fund complex to offer municipal ETFs with varied duration exposures.
Early this year, iShares introduced a series of municipal ETFs with target maturities.
Last month, State Street Global Advisors introduced a competing BAB ETF, tracking the Barclays Capital Build America Bond Index. That fund, which now manages $10 million, is up 1% since its launch.
The original BAB fund has delivered a total return of more than 6% since inception. It manages $350.4 million.
The latest fund will trade under the ticker symbol “BABI.” The original PowerShares fund uses the ticker “BAB,” while the State Street fund traders under the symbol “BABS.”
Like the existing BAB funds, the latest ETF faces a potential stumbling block, which is the expiration of the Build America Bond program at the end of this year. Though Congress is considering numerous proposals for extending the program, it is not clear what will happen to the BAB indexes should the product become orphaned.
The latest fund — as well as the two existing ones — states in its prospectus that it may transition to a general taxable fixed-income fund should the program expire.
Municipal ETFs have undergone something of an explosion the past few years. The first muni ETFs came to market in late 2007 — an inauspicious time considering the turmoil that followed the next year or so.
Since inception, the industry has rapidly accumulated assets, managing $6.94 billion at the end of April, according to the Investment Company Institute.
Just how successful municipal ETFs have been at replicating their indexes is the subject of debate.
Mimicking a stock index can be comparatively easy because stocks are liquid, fungible, and priced transparently. Municipal bonds, by contrast, are illiquid, idiosyncratic, and often difficult to value properly when they are not being traded.
ETFs face two key hurdles: the fund’s assets failing to match the index, and the fund’s share price failing to match the fund’s assets.
During the financial crisis, many municipal ETFs noticeably unmoored from their indexes, sometimes for days at a time. Since then, things have settled down.
In the more than 110 trading days since the launch of the original Invesco BAB ETF, the fund’s share price has deviated from its net asset value by more than 50 basis points only four times.