How To Pick The Right Muni Bond ETF

April 18, 2016

In State Or Out Of State?

Of course, there is also something to be said for the convenience of not dealing with paying taxes on out-of-state bonds. Some investors do simply buy in-state for the convenience, even when they may be able to earn a higher after-tax return by going out of state.

To compare in-state with out-of-state ETFs, calculate the after-tax return for the out-of-state ETF by multiplying it by the percentage you retain after paying taxes. For example, a California investor in the 10.30% state income tax bracket would multiple the return on the non-California ETF by 0.897 and compare it with the return of the in-state ETF.

Ticker Fund Dividend
Yield
Dividend
Yield
After
10.3%
CA Tax
YTM YTM
After
10.3%
CA Tax
Average
Credit
Quality
Duration
CMF iShares California Muni Bond 2.40% 2.40% 2.55% 2.55% A+ 6.66
MUB iShares National Muni Bond 2.38% 2.13% 2.96% 2.66% A+ 6.92

Data as of close 4/8/16. Source: ETF.com

Also keep in mind that some municipal bonds are taxable—such as Build America Bonds—or may be subject to the alternative minimum tax (the AMT). The interest earned on AMT munis is exempt from federal income tax, except when held by an investor who is subject to the AMT. In that case, muni interest would be subject to taxes at their AMT tax rate of 26% or 28%.

An investor who may be at risk of having their taxes based on the AMT should consult with their tax advisor prior to investing in AMT munis or ETFs that hold AMT munis. The IRS has an introductory guide to the AMT.

While municipal bonds have traditionally been favored by domestic investors who benefit from the Federal tax exemption, non-U.S. investors may also find the yields on muni ETFs (including the PowerShares Build America Bond (BAB | C-61), the SPDR Nuveen Barclays Build America Bond (BABS | D-95) and the Market Vectors CEF Municipal Income (XMPT) attractive.

Yield To Maturity & Dividends

In the cases of both individual munis and muni bond ETFs, because the yield to maturity only provides an estimate of the future returns, investors comparing muni bonds and muni bond ETFs should consider both the YTM and dividend history.

The YTM is an estimate of future returns, because the calculation makes assumptions about the treatment of cash flows and how they will be reinvested. The actual rate of return earned over the holding period will depend on whether the coupon income is spent or reinvested and the rate at which it is reinvested.

An increase in rates during the holding period may increase the return on reinvested cash flows. That could result in a holding period return that is higher than the YTM calculated on the purchase date. The reverse is also true.

The Muni ETF Difference

With an ETF, the actual holding period rate of return will also be affected by turnover in the portfolio. (The ability to reinvest cash flows at similar or higher rates is referred to as “reinvestment risk.” Like other forms of risk, it can be managed and mitigated, but it cannot be eliminated. Because ETF portfolios are managed to maintain a constant duration, the frequent reinvestment of principal at prevailing rates helps to mitigate reinvestment risk.)

Because YTM is a fixed-income calculation, it does not provide a good comparison to returns on other nonfixed-income investments. Looking at the actual dividends paid by a muni bond ETF provides a helpful way to compare the cash flow versus other nonfixed-income investments.

With an individual bond, cash flows are fixed based on the coupon rate. With an ETF, however, future cash flows will fluctuate as the portfolio changes and interest rates move up or down.

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