How To Pick The Right Muni Bond ETF

Selecting a municipal bond ETF is different from selecting an individual municipal bond, and it is also different from selecting an equity ETF.

The Tax Treatment

The interest earned on most municipal bonds is exempt from federal income taxation. Most states and cities that levy income taxes exempt their own local bonds from taxation. Thus, a California resident who owns a municipal bond issued in California, or an ETF that invests only in California municipal bonds, would earn income that is exempt from both federal and state income taxes.

Keep in mind that it is only the income that is exempt—as with other investments, capital gains are taxed.

Because of the tax advantage of owning local bonds, in-state municipal bonds issued in higher-tax states often trade at a lower yield because prices are “bid up” by local investors wanting to hold local double-tax exempt bonds.

As a result, out-of-state investors may not find yields from the specialty-state ETFs to be as attractive as some other ETFs. In addition, in-state investors should always do the math to determine if they are really better off buying local, because in some cases, out-of-state yields can be sufficiently higher to justify buying an ETF that is holding out-of-state bonds and paying the local income taxes.

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.

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.

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.)

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?

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

Notes:

• 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.