Municipal bonds have become extremely popular since the Great Recession. With their tax-advantaged status, they offer investors an attractive yield at a relatively low risk. Smaller investors who can’t afford the large face value of individual bonds have flocked into muni bond exchange-traded funds (ETFs) that offer a diversified portfolio of bonds in a single security that is traded like any other stock on an exchange.
In this article, we’ll cover some tips for investors looking to purchase muni bond ETFs, including tax implications, yield considerations and risk factors.
The interest earned from municipal bonds is often exempt from federal income tax, which is the government’s way of lowering borrowing costs and encouraging investment in infrastructure. Many cities and states also exempt investors in local bonds from paying income taxes on interest payments. For example, a New York resident who buys a New York muni bond is usually able to avoid both state and federal taxes on interest payments.
When it comes to muni ETFs, investors may want to seek out funds with holdings in their home state, in order to achieve the highest after-tax yields. This is especially true for investors in higher tax brackets who would be paying more in state and city taxes on out-of-state muni bond interest payments. In some cases, high-net-worth investors living in more obscure states may want to stay away from ETFs and build a local bond portfolio instead.
The good news is that there are several state-specific muni ETFs:
|CMF||iShares California AMT-Free Muni Bond ETF||0.25%|
|CXA||SPDR Barclays California Municipal Bond ETF||0.20%|
|PWZ||Insured CA Municipal Bond Portfolio||0.28%|
|NYF||iShares New York AMT-Free Muni Bond ETF||0.25%|
|PZT||New York AMT-Free Municipal Bond Portfolio||0.28%|
|INY||SPDR New York Municipal Bond ETF||0.20%|
In addition to state-level considerations, investors should also keep in mind that some muni bonds are taxable and others are subject to the Alternative Minimum Tax (AMT). The latter situation means that investors may have to pay tax on the muni bond interest if they are subject to the AMT by the IRS. Often times, it’s best to consult a financial advisor before investing in these funds to get a better idea of what to expect.
The yields offered by municipal bond ETFs are often quite attractive, particularly given the low level of risk, but there are a number of different yield metrics that investors should know about to help make the right decisions. Each metric has a different calculation and meaning, which makes it ideal for comparing to other income investment options. Some of the metrics may also be estimates rather than actual yields, and must be interpreted with a grain of salt.
|Yield to Maturity||Estimate of future returns that makes assumptions based on how future cash flows are reinvested. Often times, this is influenced by rising or falling interest rates and doesn’t include the impact of tax savings.|
|Dividend Yield||The actual return from interest payments rather than an estimate based on the future. This rate may vary throughout the life of the bond based on various factors and may not account for future interest rate changes.|
|Tax Equivalent Yield||The YTM divided by the reciprocal of the tax rate in order to determine the total yield including the tax advantages. This is often the best comparison for other bond and fixed income investments.|
|Tax Equivalent Dividend Yield||The dividend yield divided by the reciprocal of the tax rate in order to determine the total dividend yield including the tax advantage. This is often the best way to compare muni bonds with dividend paying stocks.|
Investors should use tax equivalent yield calculations when making comparisons, in order to accurately account for tax savings. When comparing fixed-income options, it’s usually best to use Tax Equivalent Yield (TEY) calculations, while comparisons with dividend-paying stocks are best done with Tax Equivalent Dividend Yield (TEDY) calculations. Of course, these calculations also depend on an accurate estimate of an investor’s tax rate, as well as whether the funds are AMT-Free or not.
Risk & Credit Ratings
There are two primary factors that influence a municipal bond’s risk profile – interest rate and credit risk – and certain types of ETFs target various risk profiles.
Interest rates impact muni bonds by influencing their yields, which has a direct impact on their price. Duration is used to measure the sensitivity of a bond to changes in interest rates based on its maturity and coupon rate. Bonds with lower duration are less sensitive to rising interest rates, while those with higher durations are more sensitive to rising rates. These risk factors can be helpful when positioning a portfolio for a particular interest rate environment.
Some muni bond ETFs target specific durations including:
|Ticker||Name||Average Duration||Expense Ratio|
|SHM||SPDR Barclays Short-term Municipal Bond ETF||3.17 Years||0.20%|
|SUB||Short-Term National AMT-Free Muni Bond ETF||1.97 Years||0.25%|
|ITM||Market Vectors Intermediate Municipal Index ETF||6.5 Years||0.24%|
|MLN||Market Vectors Long Municipal Index ETF||8.57 Years||0.24%|
Credit risk is the second factor influencing a muni bond’s risk profile. Often times, a muni bond’s credit rating can help quantify the likelihood of a default or missed payment. The flip side is that bonds with greater credit risk may offer greater yields, and the risks may be mitigated through diversification. Investors must decide what level of risk they are willing to assume in order to achieve a certain yield for their income portfolio.
Some muni bond ETFs targeting risk differences include:
|PRB||Market Vectors Pre-Refunded Municipal Index ETF||AAA/AA||0.24%|
|PZA||National AMT-Free Municipal Bond Portfolio (Insured)||A||0.28%|
|HYD||Market Vectors High Yield Municipal Index ETF||BBB||0.35%|
|HYMB||SPDR Nuveen S&P High Yield Municipal Bond ETF||Baa-||0.50%|
While these are the biggest risks to consider, there are a number of other risk factors that investors should factor into their decision-making including liquidity risks, market risk, reinvestment risks and inflation risk, among others.
The Bottom Line
Municipal bond ETFs have become extremely popular since the Great Recession, but investors should take time to determine the best fund for them before jumping into the market. When doing so, there are a number of factors to consider including taxes, yields and risks. Keeping these in mind, investors can ensure they’re generating the greatest risk-adjusted after-tax yields for their income portfolios.