How To Pick The Right Muni Bond ETF

April 18, 2016

Taxable Equivalent Yield

The taxable equivalent yield is the yield that a taxable fund would have to earn in order to pay the taxes and equal the nontaxable return on a muni ETF. Comparing the TEY of a muni bond ETF with the YTM of taxable bond ETF will answer the question of which is more attractive on an after-tax basis. (The TEY comparison is also helpful when comparing tax-free and taxable dividend yields.)

The taxable equivalent yield is calculated by dividing the muni’s YTM (or dividend rate, if comparing dividends) by the reciprocal of the tax rate. (It may be helpful to think of the reciprocal of the tax rate as the percentage of a taxable income that you get to keep after paying taxes.)

Ticker Fund Dividend
Yield
TEY
@39.6%
YTM TEY
@39.6%
Average
Credit
Quality
Duration
MUB iShares National Muni Bond 2.38% 3.94% 2.96% 4.90% A+ 6.92
QLTA iShares Aaa - A Rated Corporate Bond 2.96% 2.96% 2.91% 2.91% A 6.49

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

Duration & Credit Ratings

Duration is a widely used measure of interest-rate risk. (Read more about using Duration As Guide With Muni ETFs.) The market for individual bonds is generally described in terms of the trade-off between credit risk and duration—but presented in terms of maturity.

Maturity influences duration, but duration is also affected by the coupon rate. To help investors accustomed to the individual municipal bond market, the chart above presents the duration of the triple-A muni yield curve in order to be able to form a better comparison with the municipal bond ETFs.

For readability, ETFs are grouped on the chart by ranges of average credit rating. (The appendix below includes the complete list as presented in the chart.) The credit exposure in a muni bond ETF is dictated by the benchmark index used by the fund. While ETFs are well diversified, investors should be mindful of the amount of credit risk they are taking on.

Each rating agency uses its own criteria to rate issues, and the ratings reflect the agency’s opinion of the ability of the bond issuer to pay the debt and the margin of protection that is provided to bondholders.

Understand Ratings

The lower the rating, the more speculative elements there may be in an issuer’s financial condition. An investment-grade bond is a bond whose credit qualities are at least adequate to maintain debt service, but that may also have some speculative qualities.

Investment-grade ratings are “Baa” and higher from Moody’s Investors Service, and “BBB” and higher from Standard & Poor’s and Fitch. Below-investment-grade ratings suggest a primarily speculative credit quality.

The ratings on bonds may change over time. If the issuer’s ability to make interest and principal payments changes after the bond is first issued, the rating agencies may re-evaluate the bond and change their ratings as necessary.

Conclusion

So which muni ETF would you buy?

Would you buy the highest YTM? The lowest credit risk? The lowest duration?

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