Duration As Guide With Muni ETFs

Most investors know they can take on too much risk, but very few probably realize they can take on too much safety.

With this year’s volatility in global markets, municipal bond ETFs appear to be benefiting from “flight to safety” flows, with assets under management up more than 4% (through Feb. 10). Because municipal bonds are generally viewed as a so-called safe investment, it is not surprising that investors are shifting some of their assets into muni ETFs, with a significant percentage of that money going into the “safer” low-duration muni ETFs.

However, there are risks of using only low-duration muni ETFs.

As with other types of investments, it is impossible to eliminate all the risks of investing in municipal bonds because reducing some risks can mean increasing others. In some cases, taking on less investment risk may mean reducing the ability to achieve an important future goal. In other words, some investments can be too safe.

Understanding Duration

Managing a portfolio is about balancing risks against the potential for return and the investor’s goals.

For example, many investors have favored short-duration ETFs in order to avoid taking on too much interest rate (or market) risk, perhaps not realizing they are increasing their reinvestment risk. Being able to make an informed judgment about how much reinvestment risk to take on requires an understanding of how much market risk you are taking on.

Duration is the mathematical tool used by professional portfolio managers as an indicator of how much market risk there is in a particular bond or portfolio. The calculation is based on time until maturity, call features and coupon rate, and estimates market price volatility when interest rates move.

Because duration takes into account bond coupons as well as maturity, it is a better indicator of a bond’s market-price sensitivity (as yields change) than maturity or “priced to date” alone. As it is used commonly, duration most often refers to modified duration, although there are two different calculations for duration:

• Macaulay duration is the average weighted maturity of the present values of a security’s cash flows. Quoted in years, this calculation is now rarely used. Macaulay duration can be helpful to rank bonds based on relative volatility, but is less helpful in understanding the impact of interest rate changes on a bond or a portfolio.
• Modified duration is the estimated percentage change of the price of a security for an immediate 1% change in yield for the entire yield curve (known as a parallel shift in yields) and is the calculation most commonly used by professional portfolio managers. A bond (or an ETF) with a modified duration of 5.0 would be expected to decline in market value by 5% if rates immediately moved higher by 1%. The reverse would also be true—if rates decline by 1%, then that hypothetical bond (or ETF) would be expected to move higher in value by 5%.

With both calculations, the larger the number, the greater the expected change in market price when rates move. (For the rest of this article, and as is standard in the industry, duration will refer to modified duration.)

To calculate the duration for a portfolio or an ETF, the duration for each of the individual bonds in the portfolio is calculated, and then weighted to come up with the duration for the overall portfolio. Because it is only an estimate of the change in market price, using duration as a guide to volatility has its limitations. Changes in prevailing market conditions will affect the actual price movement of individual bonds differently. However, duration is an excellent tool for comparing different bonds or portfolios.

Using Duration In Your ETF Selection Process

Below are some general ideas about how you could apply duration in your selection process. The examples are drawn from national muni ETFs. Because Build America Bonds are subject to federal income taxes, the Build America Bond ETFs are also excluded here. These examples are for discussion purposes only and are not intended as a recommendation of a specific course of action for any investor, nor is there any implied endorsement or criticism of the funds used or excluded.

The appropriate duration will vary from one investor to the next, and should be revisited if there is a meaningful change in your situation or in market conditions. These tactical suggestions are not meant to be comprehensive, but to offer a starting point for your own thought process. Depending on your goals, you may be able to take on minimal risk, or your circumstances may force you to take on more risk. Using duration can you help be better informed about the risks you are taking when you make those decisions.

Diversified Asset Allocation: If you are considering adding a municipal bond ETF with a lower duration, it will provide less interest rate volatility, and you may need a larger allocation to provide the needed balance to your equity risk.

If your financial plan provides a recommended asset allocation mix, compare the duration of the fixed-income benchmark used against your proposed ETF. Using a lower-duration ETF than the benchmark could be a less effective diversifier. Conversely, an ETF with a higher duration should bring greater noncorrelating performance than modeled in your plan, and could permit a slight reduction in the percentage allocated to fixed income.

The SPDR S&P 500 ETF (SPY | A-98) is shown as a proxy for equity market exposure. Note how the year-to-date performance of these selected muni ETFs goes up along with duration. Keep in mind that the higher price sensitivity can go both ways—in a rising rate environment, a higher duration ETF would be expected to decline more quickly. But when paired with other asset classes, the ideal is for the portfolio to have an overall lower risk profile.

Asset Preservation, with Income a Secondary Consideration: If you will be holding your muni ETF for a short-to-intermediate time frame, you may prefer to favor a comparable short-to-intermediate duration ETF so as not to take on too much interest rate risk.

If rates move higher before you sell, an ETF with a lower duration would be expected to decline by less than an ETF with a longer duration. Keep in mind that income earned may be able to offset some of the potential decline in market value, but generally, when asset preservation is the primary objective, duration selection should be in line with anticipated liquidity needs.

For example, looking at the Pimco Short Term Municipal Bond ETF (SMMU | C-47), if you needed to sell in one year and rates moved higher by 1%, you would expect your share price to decline by approximately 2%, and to have collected almost 1% in income over the year, for a negative total return for the period. If you were comfortable that you would not be forced into selling in one year, you may be more comfortable with the 2.03 duration of that ETF.

Noninvestment-grade credit exposure should be within the overall portfolio risk tolerance, which most often would be a percentage of the overall fixed-income allocation. (Dividend yield is blank if there is less than 12 months of data available.) (Data from ETF.com Screener.)

Income Generation: You may wish to consider intermediate to longer-term duration funds for the higher amounts of current income. That higher income (and higher duration) will mean more market risk, an important consideration should you decide to sell in the future.

Upper-income-tax-bracket investors will want to verify their status regarding the AMT before considering a muni ETF that includes AMT-eligible income. Inclusion of noninvestment-grade exposure should be based on portfolio objectives and not on the amount of incremental income expected.

Income Generation with Principal Preservation: As with a portfolio of individual bonds, you could consider assembling a “laddered” portfolio of ETFs with diversified allocations to several funds with increasingly higher durations.

Additional Comments

Bonds are widely thought of as “safe” investments, primarily because of the predictability of the interest income and the fixed maturity dates. Of course there are risks to investing in bonds—most familiar are credit risk and market risk, but there are others.

Credit risk refers to the ability of an issuer to be able to fulfill their obligations as they come due.

Market risk: Because bonds sold prior to maturity may be subject to a loss if rates move higher, municipal bond ETFs are also subject to market risk. As markets move and sentiment changes, actual changes in market value can be greater or lesser than expected.

• Reinvestment risk is the risk that the interest or the matured principal of a bond may not be able to be reinvested in a similar investment at a comparable yield. Reinvestment risk goes up as maturity dates get shorter and as prevailing interest rates decline.
• A laddered bond portfolio has equal amounts of principal maturing at regular intervals throughout the life of the portfolio and is considered an interest-rate-neutral strategy, because it favors neither a rise nor a fall in interest rates. By having bonds rolling off on a regular basis, an investor may be able to avoid missing the opportunity of locking in attractive rates when yields are high, or having too much of a portfolio locked into lower rates. An ETF investor can employ a similar strategy by using funds of increasing durations for each rung of the ladder. The additional benefit of the ETF ladder is that the funds are managed to maintain a fairly constant duration, so unlike a bond portfolio that will need regular maintenance, a laddered ETF portfolio may be easier to supervise and manage.
• Finding the duration of a municipal bond ETF is easy on www.ETF.com. Go to ETF ANALYTICS & DATA / ETF Screener & Database, and after selecting the ETFs you are researching, click on the Fundamentals tab.

Patrick Luby is the author of www.IncomeInvestorPerspectives.com and has decades of experience in helping advisors and investors understand the municipal bond market.

The opinions expressed and the information contained herein is based on sources believed to be reliable, but its accuracy and appropriateness is not guaranteed. Past performance is interesting but is not a guarantee of future results. 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. Investments in bonds and fixed-income ETFs are subject to gains/losses based on the level of interest rates, market conditions and changes in credit quality of bond issuers. Additional information available upon request.