Van Eck is set to launch an exchange-traded fund on Tuesday named the Market Vectors Pre-Refunded Municipal Index ETF.

It will track the Barclays Capital Municipal Pre-Refunded-Treasury-Escrowed Index.

Say what?

OK, it's obviously a muni ETF. But what's a "pre-refunded Treasury escrowed" bond?

Just as anybody might think about refinancing their home mortgage to lower costs, municipalities and agencies do much the same.

"They can reduce their interest expense in issuing public bonds by entering into a pre-refunded activity," said Jim Colby, senior municipal strategist and portfolio manager at Van Eck Global in New York City.

Here's how a "pre-refunded activity" works. Say a city issues $100 million worth of bonds to fund a water facilities project. A few years ago, the deal came to market with interest payments to investors of 6%. But now, with interest rates for 30-year triple-A munis hovering around 5%, the city decides to cut its costs. So it reissues more bonds at the lower rates covering the exact same project.

The municipality then takes the proceeds from that second issue and buys similar-termed Treasuries. Since most munis have call features prior to maturity, the Treasuries are put in an escrow account to fully fund the interest and principal of the munis on their first call dates.

Win-Win? 

It sounds like a great idea for the city. But it can also be a great idea for investors, says Colby. "Suddenly, you have a bond that's no longer an obligation of that city or municipality," he said. "It's now an obligation of the U.S. government through Treasuries."

In other words, investors can buy these so-called pre-refunded escrowed munis and get the benefits of a tax-free income stream. And, at the same time, investors basically upgrade their credit quality to U.S.-guaranteed Treasuries.

"This isn't something that's new to the muni marketplace. Pre-refunding has been going on for years, but usually only available to institutional investors," said Colby. "But these remain the easiest munis to price and the easiest to trade because of their higher credit quality."

In these times, obviously that can be a big plus for investors. "Price volatility will be a factor, just like in any bond fund," said Colby. "But the fund's index currently has a duration of 3.3 years and has an average maturity of just over four years. So combining the relatively short nature of the index and the relatively high quality of the credits, this will make for an attractive profile for many investors."

In the last quarter of 2008, Treasury yields declined to historic lows. The benchmark 10-Year Treasury note is now trading around 2.8%. By contrast, a similar maturity triple-A rated muni is around the same rate if not slightly higher.

Right now, PRB's index has a yield of 1.55%. But similar-termed Treasury notes are yielding almost exactly the same. Treasuries are tax-exempt locally, whereas muni funds are at least tax free on the federal level. At a 35% tax rate, for example, Colby says PRB's yield would equate to about 2.3% on a tax-equivalent basis.

Tax Breaks 

Although Treasuries gain in such a comparison when local tax breaks are considered, those will typically be much smaller on a relative basis to not paying federal taxes, he added.

"There are other short-term muni ETFs in the market," said Colby. "But PRB will be the first in the market to provide access to pre-refunded munis."

Interestingly enough, based on the ETF's index, yields for PRB should not only beat short-term Treasuries but they'll also significantly be greater than yields available from money market funds.

The expense ratio for PRB is expected to be 0.24%. It's scheduled to be traded on the NYSE Arca exchange.  

"Liquidity and the credit quality of munis is a critical factor in today's market," said Colby. "This should be another tool for fixed-income investors to build diversified portfolios under current market conditions."

The ETF's prospectus can be found here.