The muni bond market was hit with the latest wave of bad news Thursday, prompting a selloff that sent the market to its lowest level since the financial crisis. A New Jersey agency was forced to cut the size of a bond issue by about 40% because of mediocre demand, and pay a higher rate than expected. And mutual fund giant Vanguard Group shelved plans for three new muni bond funds, citing market turmoil.

“We believe that this delay is prudent given the high level of volatility in the municipal bond market,” said Rebecca Katz, spokeswoman for the nation’s biggest fund company.

The market has fallen every day this week, and investors have been net sellers of their holdings in municipal-bond mutual funds for nine straight weeks, according to fund tracker Lipper FMI.

Yields on 30-year triple-A rated general obligation bonds shot higher to 5.01% on Thursday, reflecting a spike in perceived risk, according to Thomson Reuters Municipal Market Data. The last time those bonds yielded 5% was Jan. 30, 2009, during the financial crisis.

Amid the selloff, public borrowers such as states and utilities face a wave of refinancing stemming from deals cut mostly during the crisis. The deals involved letters of credit from banks that were designed to keep financing costs down for government entities in need of cash.

Though the financing deals can be meant to last decades, the letters of credit underpinning them are expiring sooner. That could force the borrowers in many cases to pay higher interest rates or seek guarantees at higher costs. For the weakest borrowers, new guarantees may not be available and refinancing too costly. There are about $109 billion worth of letters of credit and similar backstops expiring this year, according to Bank of America Merrill Lynch. Some $53 billion in letters of credit alone is expiring this year, according to Thomson Reuters.

“Municipalities may be hard-pressed to come up with this money or refinance this debt,” said Eric Friedland, a municipal analyst at Fitch Ratings. The ratings firm is scouring to identify risks among weaker municipalities that are seeking to renew these deals, and says it could downgrade some.
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The short-term squeeze is unusual in the $2.9 trillion municipal bond market. Most debt is paid back over decades. And state and local governments generally don’t need to borrow money to fund their daily operations. The long-term nature of the market is a key reason why most experts don’t see the problems with state and local government debt spiraling into another financial crisis. Analysts say that many large states and cities with good credit ratings have been able to roll over deals well ahead of their expiration.

But there are parts of the market where short-term cash crunches could emerge, leading municipalities to potentially default on their debts. The risks could spill over to banks that backed bonds with the letters of credit.
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The biggest concerns, analysts say, are smaller muni borrowers such as hospitals and schools that have subpar credit.

Municipalities borrowed $122 billion of variable-rate demand debt in 2008, roughly twice the amount of these types of loans borrowed the year before, according to Thomson Reuters.

Rollover crunches were a major part of the financial crisis, as banks that had relied on short-term debt couldn’t borrow and became insolvent. More recently, rollover issues contributed to Greece’s financial crisis.

Banks are reluctant to renew the letters of credit in part because of impending rules that restrict the amount of risk they can take.

Besides banks, one provider of muni letters of credit is the giant California pension fund, the California Public Employees’ Retirement System, which has back-stopped $2.5 billion of adjustable-rate bonds.

Calpers’ chief investment officer, Joe Dear, said in an interview that the pension fund partly uses the letters to make it easier for local California entities to borrow money, but it has no plans to ramp up its involvement in such deals.

The past year was no doubt one of the most important in the industry’s short history, as the products continued to gain market share in new markets around the world. With 2011 well underway, the new year figures to be full of exciting developments for the industry as well. Below, we highlight several predictions for the ETF industry in 2011, our thoughts on what headlines might shape the next phase of the ETF boom.

1. VWO Surpasses EEM in Assets Under Management (AUM)

Okay, so this is an easy one. The two most popular emerging market investments continue to thoroughly dominate the Emerging Market ETFdb category, combining to account for more than $90 billion of the $110 billion or so in total. Both of the funds track the MSCI Emerging Markets Index, and as a result are largely similar in terms of composition and individual weightings. The most significant difference between the funds – besides the issuer name – is that VWO charges an expense ratio that is roughly one-third that of EEM. As a result, cost conscious investors have been piling into Vanguard’s VWO instead of iShares’ EEM…

This development will underscore the importance of low fees to ETF investors, and perhaps inspire other firms to slash their expense ratios in an effort to gain market share. There are several match-ups where cost differentials could be critical to future growth, including the head-to-head gold ETF match-up as well as a variety of country-specific ETFs.

2. New Country ETFs Debut

This past year saw the release of several country ETFs targeting once hard-to-reach international markets; countries that are now available in ETF form include the Philippines (EPHE), New Zealand (ENZL), and Egypt (EGPT), just to name a few. Moreover, a number of additional products appeared in other markets such as India and Brazil, targeting unique aspects of their respective economies…

3. Volatility ETNs – But Not the Traditional VIX

Last year saw a surge in the number of products offering exposure to volatility, an asset class that was previously beyond the reach of many investors. While all of the VIX ETPs currently on the market are linked to indexes based on the volatility of the S&P; 500, there seems to be an opportunity in harnessing the volatility of other equity benchmarks and even other asset classes. Currently, there are VIX levels for oil, gold, and a variety of other commodities and indexes as well. Given the popularity of the current crop of VIX ETNs, it is rather odd that no one has thought of this yet, especially considering the often significant volatility of gold and oil…

4. Small-Cap Europe ETFs

IndexIQ, the firm perhaps best known for its hedge fund replication ETFs, has been one of the few firms to offer investors quality exposure to small caps in foreign markets. Their four core small cap funds, which target the small cap securities in Australia (KROO), Canada (CNDA), Taiwan (TWON), and South Korea (SKOR), have been slow to build assets despite the fact that they arguably offer more “pure play” exposure to the local economies and tend to not be as prone to heavy exposure in oil and banking firms as their large-cap peers…

5. At Least 50 ETFs Close

While there will almost certainly be a net gain of funds in the ETF world this year, it is undeniable that many ETFs are money losers for their issuers. More than 450 ETFs finished 2010 with less than $50 million in assets, a common rule-of-thumb breakeven point in the ETF industry. Although many of these funds are relatively new products that are still hitting the sweet spot on their growth curve, many of them have been around for quite a while and are unlikely to suddenly see a surge in assets. As issuers look to cut the fat from their product lineups, look for at least 50 ETFs to close down this year.

6. 2011: Year Of the Non-BRIC Emerging Market ETF

If 2010 was the year of the commodity ETF, 2011 will be the year of the non-BRIC Emerging Market ETF. After billions of dollars flowed into BRIC-focused ETFs last year, expect investors to look towards smaller or lesser-known emerging markets in 2011 as an option to move away from U.S. exposure and identify markets poised to deliver solid long-term results…

7. More Online Brokerages Jump on the ETF Bandwagon (I’m Looking at You, E-Trade)

As further evidence of the growing importance and recognition of ETFs, numerous brokerage houses announced plans to offer many ETFs commission-free to their clients, a development that may accelerate the shift from mutual funds to ETFs among individual investors. With the recent proposal of a revived FocusShares, it appears that Scottrade will likely join the growing chorus of online brokerages to offer commission-free trading on a number of products to their clients…

8. India ETFs Catch Up to China ETFs

While China may still be an emerging market, its ETF lineup is highly developed; currently over 150 ETFs offer at least some exposure to the country, with 16 putting a majority of their assets in Chinese stocks. This number increases even more if investors add in auxiliary China exposure in the form of Hong Kong securities or those from Taiwan. This is in sharp contrast to the situation in India, where just 43 funds offer exposure to the country and just five have more than half of their assets in the sub-continent. In fact, more funds offer exposure to either Peru or South Africa than India, the world’s most populous democracy…

9. Active ETF Push Continues

With ETF assets hitting $1 trillion in late December, the vast majority of assets continue to be in “plain-vanilla” funds tracking standard indexes such as the S&P; 500 or the Russell 2000. Active ETFs, once billed as the “next big thing” in the industry, have been slow to catch on with investors. Grail, the San Francisco firm behind one of the first true active ETFs, recently indicated in an SEC filing that it is on the verge of a sale or liquidation. While a handful of active PIMCO bond funds have had some success, assets in active ETFs have generally been disappointing…

10. More Funds in the Underdeveloped Currency and RE Categories

Despite the massive markets that exist in both the foreign currency and real estate worlds, the number of ETF products in these two categories leaves much to be desired. Just 14 funds track the real estate market in the U.S., while just 11 exist in the Global Real Estate ETFdb Category. While the currency ETP lineup is comparatively more robust with 30 funds, it is pretty small when one considers that over $2 trillion trades hands every day in the currency market, suggesting that far more potential exists in this slice of the market as well…

11. VIX ETPs Contraction

The Rydex MSCI All Country World Equal Weight ETF (NYSEArca: EWAC) tracks the equal-weighted MSCI All County World Index, which comprises more than 2,400 stocks from 24 developed and 21 emerging market countries, according to the company’s fact sheet. The fund’s components are rebalanced quarterly to maintain the equal weighting.

EWAC’s focus is on large-cap firms; the median market capitalization of companies in the MSCI ACWI Equal Weighted Index is $11.3 billion.

Equal weighting—as opposed to weighting by market capitalization—is an alternative approach to indexing that’s increasingly attracting the attention of both investors and fund sponsors. As of late October, the Rydex S&P; Equal Weight ETF’s (NYSEArca: RSP) year-to-date returns were more than twice as much as its market cap-weighted counterpart, the SPDR S&P; 500 ETF (NYSEArca: SPY).

According to Rydex portfolio strategist Tony Davidow, the quarterly rebalancing provides a quasi-active component to his firm’s equal weighted funds and may be part of the secret of their relative outperformance.

“We’re essentially selling the winners high and buying the underperformers low,” said Davidow.