Using ETFs To Build A Sustainable Muni Portfolio

Municipal bonds for investors have been spoiled. Through the years of the bull market in bonds, holding a portfolio of munis was typically a low-maintenance and low-risk endeavor.

But not anymore. For municipal bond investors, life is getting more difficult.

The change in the interest rate environment means that simply buying and holding munis to maturity may not be as rewarding as it once was.

However, because of the portfolio risks that can result from being poorly diversified, a rising-rate environment shouldn’t necessarily mean avoiding bonds. In addition, the growing concerns about underfunded pension obligations among bond issuers mean that credit risks are rising and that diversification is growing in importance as a risk management tool.

How ETFs Can Manage Risk

Fortunately, there are strategies that investors can use in a rising rate environment to protect existing income (in case rates go lower) while retaining the flexibility to take advantage of potentially higher rates in the future.

And the structure of ETFs and the available variety of muni-bond ETFs can help investors manage their muni portfolio risks and build a broadly diversified and low-maintenance municipal bond portfolio.

Many muni investors are familiar with the laddered portfolio strategy, in which the total muni allocation is divided equally across sequential maturities. For example, a $1 million portfolio could be set up with $100,000 in maturities from 1 to 10 years. A ladder strategy is interest rate neutral—it favors neither a rise in rates nor a decline in rates.

A laddered muni portfolio can be built using a mix of any of the existing muni ETFs.

Two Examples Of How To Build A Ladder

Below are two hypothetical examples, one using BlackRock’s iShares iBonds Term Muni Bond ETFs, which will all shorten in duration as time passes, reducing the interest rate risk, but also necessitating future reinvestment decisions as each ETF matures.

The second example uses VanEck Muni Index ETFs. Because these are managed to track an index with a duration target, the portfolio would be expected to maintain a fairly steady duration, and would not require reinvestment maintenance as the maturing iBonds would.

In both cases, because of the exchange-traded liquidity of the ETFs, should the need arise to rebalance either portfolio, doing so may be easier than with a portfolio of individual bonds.

A laddered portfolio can be assembled with as high or low duration as the investor wants or needs.

Barbell Portfolio Strategy

Investors who want to retain some tactical flexibility for a rising rate environment may wish to consider a barbell portfolio strategy. This is a variation on the ladder, but instead of having bonds mature every year, the money is split into short and long maturity investments that average out to the same (or similar) target maturity as the ladder strategy; for example, by halving a $1 million portfolio into short and long “buckets.”

In this way, if rates go lower, half of the portfolio benefits from having been invested at higher rates. But if rates go higher, when the shorter bonds mature, the principal can be reinvested at higher rates.  A barbell portfolio can also be implemented with ETFs by weighting the durations of each fund or using target-date ETFs.

These hypothetical portfolios are not intended to suggest a specific solution for any investor.

ETFs To Adjust Overall Risk

ETFs can also be added to an existing portfolio of individual bonds to adjust the overall risk characteristics.

For instance, investors with a laddered portfolio may wish to consider reducing some of their long-duration positions and reinvesting in very-low-duration muni ETFs (such as the PowerShares VRDO Tax-Free Weekly Portfolio (PVI) or the PIMCO Short Term Municipal Bond Active ETF (SMMU)). This in effect shifts their ladder from equal-weighting each maturity rung to over-weighting the shorter rungs of the ladder.

Because most municipal bond ETFs are managed to maintain a constant duration, they can be held for as long as they remain appropriate. Or investors can select one (or a mix) of target-date ETFs that will shorten in duration as time passes—just as individual bonds do. Using target-date ETFs means that when the shares are redeemed, the holder will have to reinvest their principal—a good thing if prevailing rates have moved higher (but not as desirable if rates have declined).

With 36 different muni ETFs to select from, there are many variations of how to assemble a portfolio. Depending on the size needed for each position and the liquidity of the underlying sector, in many cases, it may be possible to buy more shares than ordinarily trade on an average day.

See this article for additional insight about trading ETFs. To learn more about ladder and barbell portfolios, read Fixed Income Portfolio Structure. For additional guidance about selecting individual muni ETFs, please see this article.

Patrick Luby is a municipal bond market and portfolio strategy specialist and the author of www.IncomeInvestorPerspectives.com.

At the time of writing, the author held none of the securities referenced. 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.