Investors are using ETFs to buy a basket of municipal bonds and reduce the risk of an individual local government defaulting on its obligations.

Also, the tax break on income from muni bonds makes the yield attractive to some investors.

“Municipal-bond funds in general are most suitable for use by investors in high annual tax brackets for use in their taxable accounts. The reason is that interest income from municipal bonds is tax-free at the federal level. Therefore, investors with the highest marginal tax rates are able to best utilize the tax-shielding profits and maximize their return on the bonds,” Timothy Stratus wrote on Morningstar.

iShares S&P National Municipal Bond Fund (NYSEArca: MUBcan reduce the risk of exposure to municipal defaults as municipalities have been blind-sided by falling tax receipts in the wake of the housing crash. MUB can also be used as a compliment for single-issue holdings, reports Strauts. MUB yields 1.76% [Are Muni-Bond ETFs Facing an Inflection Point?]

ETFs that invest in muni-bonds are a boon for investors that invest in single-issues because these are ill-liquid after issue and investors must hold them until maturity. Holding a percentage of your municipal-bond allocation in the more-liquid ETF form will give you the ability to sell if you get in a bind, minus the trading spread.[Bond ETFs Hit by Erratic Trading]

Municipalities are in a bind of budgetary problems that are not easily worked out due to the housing bust. Many are working out budgets that cut costs to match lower revenues.

“There will be a terrible problem and then the question becomes will the federal government help. If the federal government will step in to help them, they are triple-A. If the federal government won’t step in to help them, who knows what they are,” Warren Buffet stated. [Muni-Bond ETFs Yawn at Latest Bankruptcy]

Other muni-bond ETFs:

  • PowerShares Insured National Muni-Bond (NYSEArca: PZA
  • SPDR Nuveen Barclays Capital Municipal Bond (NYSEArca: TFI

Tisha Guerrero contributed to this article. 

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.