The current ultra-low rate environment has prompted investors of all styles to scour the markets for meaningful sources of yield without incurring handfuls of volatility. Looming economic uncertainties all over the globe have made it even more challenging for investors looking to tame their portfolio's volatility while generating income at the same time. One particular breed of fixed income securities, however, warrants a closer look from income-hungry investors: enter municipal bonds. James Colby, portfolio manager and senior municipal strategist at Market Vectors ETFs in New York, recently took time out of his schedule to discuss the state the muni bond market, as well as offer insights into how ETFs offer a compelling way to access this asset class.

Municipal Bonds (MB): What would you consider to be the most compelling characteristics of municipal bonds amid the current low-rate environment?

James Colby (JC): In addition to their low volatility, municipal bonds have continued to deliver yield on a taxable equivalent basis higher than that of most other asset classes. Only recently has the ratio of muni yields (AAA quality) to Treasury yields dipped below 100%. Total return for investment grade municipals (Barclays Municipal Bond Index) is 6.36%, and 15.78% for municipal high yield (Barclays Muni High Yield Index) through October 31, 2012. Despite downgrades, the credit quality for the broad market, covering as many as 60,000 issuers, is still in the range of AA.

MB: There have been a few pundits saying that they expect a wave of municipal bond defaults in the not-so-distant future. How do you respond to those predictions?

JC: Clearly investors have responded to those assertions by pouring nearly $50 billion (year-to-date) into municipal funds and ETFs, demonstrating their renewed confidence in the resilience of this asset class. While the notion that there would be strains brought upon the budgets of municipalities is accurate, the prediction of waves of defaults was reckless and not based upon a clear understanding of how default/bankruptcy differs for municipalities as opposed to corporates.

MB: What have default rates been historically? What typically happens in the event of default?

JC: Municipal default rates have historically been less than half of that of the corporate high-yield market. Municipal bankruptcies by all accounts average 3-5% in studies done by ratings agencies. Those credit impairments have, in fact, been on the decline during the past two years. When an impairment occurs, often a restructuring results, which historically allows bondholders to recover as much as 70%, as to principal and interest; far higher than in the corporate marketplace.

MB: What are the benefits associated with accessing municipal bonds through the ETF wrapper? What are some potential drawbacks?

JC: The benefits from an ETF wrapper are several. Whereas the cost of buying or selling a bond can be significant and unclear, the cost of accessing tax-free income from an ETF is visible in the spread of the quoted stock and the much lower management fee charged, compared to mutual funds. Further, the investor is not limited to how much cash to invest compared to the $5,000 minimum required for individual bonds. And the ETF is broadly diversified, which means that the investor is insulated from sudden illiquidity or credit concerns associated with individual holdings. Finally, dividends are tax-free and are delivered monthly as opposed to semi-annual coupon payments from bonds.

MB: How would a worst-case scenario outcome regarding the "fiscal cliff" potentially affect municipal bonds?

JC: It is difficult to assess the worst-case scenario, but if the benefit of tax-free income is capped at some rate say 28% - then municipal rates would have to rise to compensate holders for that portion being taxed. That rise in rates flows immediately to the issuers, increasing their cost of capital. And, instead of just taxing the wealthy, the higher cost of capital is then passed on to all taxpayers of those communities. Thus, everyone then pays what I call higher stealth taxes, and perhaps make municipals a little less an attractive alternative.

James Colby, portfolio manager and senior municipal strategist at Market Vectors ETFs in New York. Market Vectors has six municipal bond ETFs with more than $2 billion in assets under management.