With volatility in global markets and the challenges of investing in municipal bonds continuing to grow (reduced liquidity, low rates, under-funded pensions, increased political risk, etc.), the interest in professionally managed muni ETFs has gone up.
When selecting municipal bond ETFs, all of the other standard guidelines of a fixed-income portfolio apply, including:
- Don’t select based only on the highest yield available. Be sure you understand the other risks involved in generating that yield.
- Don’t reach for yield—when considering high-yield investments, it should be for a portion of the total fixed-income allocation. (ETFs provide an easy way to achieve very broad credit diversification.)
- Don’t try to time interest rates. (Click here to read my article explaining the difficulty of trying to time rates.) Let your asset allocations be determined by your goals and investment policy. The interest-rate environment can influence how much interest-rate risk you take on, but should not lead you to eliminate or reduce your allocation to bonds. Keep in mind that overweighting your cash allocation at the expense of your fixed-income allocation may not sufficiently diversify your equity exposure and can increase your reinvestment risk.
By understanding how to evaluate duration, dividends, yield to maturity, taxable equivalent yield and credit risk when selecting a muni ETF, investors can be more confident in using ETFs as a liquid and well-diversified way to replace or add to their exposure to the municipal bond market.
Data as of close 4/8/16. Source: ETF.com
- In the chart, the Generic Muni Triple-A yield curve is based on The Consensus Municipal Bond Triple-A G.O. Par Bond Scale, published by Municipal Market Analytics LLC. www.mma-research.com.
- The chart (and the table above) exclude BAB and BABS, as those ETFs invest in taxable Build America Bonds. (Build America Bonds share similar creditworthiness as other municipal bonds, but are federally taxable. While they can be an attractive alternative to other taxable bond ETFs, they are outside the scope of this article, which is looking only at federally tax-exempt municipal bond ETFs.) The chart also excludes XMPT, because it invests in leveraged closed-end muni bond funds, and while it has a long duration, a specific duration value was not available.
- ETF investors not already familiar and comfortable with the municipal bond market may wish to start by visiting the Municipal Securities Rulemaking Board’s Education Center.
- Experienced municipal bond investors who want to learn more about the ETF wrapper should start with the ETF.com Bond Channel.
- Equity investors unfamiliar with bond investing may wish to read my article Bonds Are Not Stocks, which explains what equity investors should know about bond investing.
Patrick Luby is a fixed-income portfolio strategy specialist and the author of www.IncomeInvestorPerspectives.com. He has helped many of the industry’s best advisors and their investor clients understand and navigate the municipal bond market for many years. This is not a recommendation to buy, sell or hold any of the securities or strategies mentioned. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Information is based on sources believed to be reliable, but its accuracy is not guaranteed. Additional information is available upon request.