Municipal bonds are popular investments due to their government backing and tax incentives. In many ways, these bonds provide the best of both worlds by combining the after-tax yields of corporate bonds with the safety of Treasury bonds. The benefits are particularly acute for high net worth individuals who have higher tax rates than the average person.
Muni bonds are often laddered in order to create a steady stream of income over time rather than waiting for a single lump sum. For instance, an investor may purchase five different bonds with expiration dates staggered every year over the next five years. Retirees benefit from predictable income coming in each year, while long-term investors benefit from mitigated interest rate risks since not all bonds are purchased at the same time.
Muni Bond Ladder Funds
Municipal bond ladders are great for high net worth individuals with the capital to purchase a portfolio of individual bonds; a basic ladder with six rungs would cost a minimum of $30,000 to build since muni bonds often trade in $5,000 minimums. Most financial advisors would also recommend about ten runs to manage the risk of any individual bond faltering, which increases the minimum investment to $50,000.
On the other hand, muni bond ladder funds provide an affordable alternative to individual investors who may not have an extra $50,000 lying around. By employing the same strategies, these funds provide a consistent yield and risk diversification compared to funds holding same-maturity bonds. The only additional cost is the expense ratio associated with managing the fund, although these costs are mitigated by the fund’s economies of scale and risk diversification.
Muni bond ladder funds also provide virtually guaranteed returns over time. With traditional bond funds, investors may not recoup their original investment if interest rates push bond prices lower. Muni bond ladder funds, however, can be purchased to match an investor’s portfolio maturity date, which enables them to collect the full investment principal when the fund expires, as well as all of the interest payments made over time.
Selecting the Right Funds
There are many different municipal bond ladder funds from which to choose, both in terms of the issuer, maturity date, and types of holdings.
The most important factors to consider include:
- AMT-Free: Most muni bonds are exempt from the Alternative Minimum Tax calculation, but there are some bonds that don’t meet the criteria. Before buying a bond ladder fund, ensure that the fund is AMT-Free to avoid these taxes.
- Credit Quality: Most muni bonds have excellent credit ratings, but some higher-yield bonds may be worth reconsidering. For instance, Puerto Rican bonds have significantly greater risk because they do not fall under Chapter 11 protection.
- Maturity: Muni bond ladder funds are best held until maturity in order to guarantee the repayment of principal. In general, investors should try and purchase funds with maturity dates that correspond to their desired portfolio maturity.
- Yield: Muni bond ladder funds offer a variety of different yields that depend on their maturity, credit quality, and other factors. Investors should ensure that these yields are appropriate for their overall portfolio strategy.
The two most popular muni bond ladder fund ETFs issuers include:
Watching Your Step
Municipal bond ladder funds face many of the same risks as traditional muni bond ladders, which investors should carefully consider.
Some key risk factors include:
- Callable Bonds – Many muni bonds are callable, which means that the issuer can choose to pay off the bond early. In these instances, the fund must replace the bond with a similar bond that often pays a lower interest rate.
- Declining Duration – Traditional bond funds buy new bond issuances that have maturities with a certain range in order to keep a consistent duration. By contrast, muni bond ladder funds are designed to terminate at a set date in the future.
The Bottom Line
Municipal bonds are attractive investments that provide both safety and tax advantages compared to other fixed-income investments. While buying individual bonds is one option, many investors may want to consider muni bond ladder funds as a way to gain diversified exposure to the asset class and ensure the safety of their principal investment.