Journal of Financial Planning; April 2014
Tom Lydon is editor of ETFtrends.com and president of Global Trends Investments, a registered investment adviser. He is a frequent contributor to major print, radio, and television media.
Municipal bonds are an important part of a diversified fixed-income portfolio, providing a yield advantage over U.S. Treasuries. While munis have weakened on interest-rate risk and troubles in cities like Detroit, advisers can use municipal bond exchange-traded funds for targeted exposure to the space.
Two of the largest broad municipal bond ETFs, the iShares National AMT-Free Muni Bond ETF (MUB) and SPDR Nuveen Barclays Municipal Bond ETF (TFI), provide fixed-income investors with attractive yields when factoring in federal income tax. Specifically, MUB shows a 30-day SEC yield of 2.54 percent, or a tax equivalent 30-day SEC yield of 4.49 percent for investors in the 43.4 percent tax bracket. Meanwhile, TFI comes with a 2.51 percent 30-day SEC yield, or a taxable equivalent 30-day SEC yield of 4.43 percent.
Advisers can best use these muni ETFs in a taxable account for investors in high tax brackets to help diversify a fixed-income portfolio. Last year, we saw the tax breaks expire and a new 3.8 percent Medicare surtax, which pushed up short-term capital gains from 35 percent to 43.4 percent for the top tax bracket.
The greatest risk to the municipal bond market is rising interest rates. Benchmark 10-year Treasury yields have increased from the May 2013 low of around 1.6 percent to as high as 3.0 percent by the end of the year. Interest rates, though, began to dip again this year as investors move back into bonds.
If rising rates start to threaten fixed-income assets again, the higher yields in munis will help cushion the fall in prices. Nevertheless, advisers who are still wary about rising interest rates can consider moving down to short-term debt. For instance, the SPDR Nuveen Barclays Short Term Municipal Bond ETF (SHM) and the iShares Short-Term National AMT-Free Muni Bond ETF (SUB) show an average duration of 2.9 and 2.02 years. SHM has a 0.50 percent 30-day SEC yield, or a 0.89 percent taxable equivalent yield, while SUB has a 0.24 percent 30-day SEC yield, or a 0.43 percent taxable equivalent yield.
Investors will have to sacrifice yield for the safety of shorter debt, but the recently launched Market Vectors Short High-Yield Municipal Index ETF (SHYD) promises to generate attractive yields with an effective duration of 4.98 years. The underlying benchmark index yields about 5.4 percent, or a taxable equivalent of 8.9 percent for the highest tax bracket, but the fund has increased exposure to non-investment grade debt, which makes up about 75 percent of the portfolio.
Because of its yield and duration profile, SHYD shows similar performance to high-yield corporate debt but trades at a fraction of the default risk associated with speculative-grade debt. According to Moody’s Investors Services, high-yield muni bonds had an average 0.98 percent default rate between 1970 and 2012, and high-yield corporate debt had an average default rate of 4.55 percent.
Default risk has been a hot topic in the munis space after Meredith Whitney notoriously made a call on widespread municipality bankruptcies. Smaller municipalities have declared bankruptcies, including Stockton, San Bernardino, and Vallejo in California, but the Detroit debacle and trouble in Puerto Rico ruffled investors’ confidence.
Investors, though, can limit default risk through insured municipal bond exposure, as provided by the PowerShares Insured National Municipal Bond Portfolio (PZA). Insurance companies would help mitigate the default risk, but most insured debt is issued with long maturities (PZA has an effective duration of 9.1 years). PZA also comes with a 4.06 percent 30-day SEC yield, but you will have to be comfortable with the longer duration.
Alternatively, the db X-trackers Municipal Infrastructure Revenue Bond Fund (RVNU) skirts the default risk in general-obligation munis associated with municipal issuers like Detroit by investing in revenue-generating projects. RVNU is the first ETF to focus exclusively on revenue bonds, or munis, that are supported by revenue from projects such as toll roads or bridges, providing investors with stable income and conservative positioning without the fear of capital loss resulting from higher muni bankruptcies.