Municipal Bonds
Municipal bonds, or “munis,” may provide tax-free returns and a steady stream of income. Cities, counties and states issue municipal bonds to fund projects such as schools, hospitals and airports. Many consider these to be the next safest category of investments behind Treasuries. Defaults have happened, but they’re rare.
Municipal bond ETFs hold a diverse collection of state and project development initiatives. The two major types of municipal bonds are revenue bonds and general obligation bonds. General obligation bonds are supported by taxes, whereas revenue bonds are supported by the income generated by projects funded. Both types are tax-exempt and relatively low risk.
Purchasing muni bond ETFs is not totally free of risk:
- Poor economic conditions and lower tax revenues could lead some states to default – risk is less severe for general obligation bonds and more severe for munis tied to private institutions.
- Increases in future inflation also translate to lower returns in bonds with more long-term maturity dates.
- An issuer may not meet all financial obligations. Credit ratings agencies will report the credit risk of an issuer.
- If one’s marginal income-tax rate reduces, it may be better to consider higher-yield bonds than holding onto municipals.
- As interest rates rise, newly issued bonds will pay higher yields than existing ones.
You can find a complete list of muni bond ETFs in our ETF Analyzer.
Corporate Bonds
Corporate bond ETFs cover debt issued by publicly-traded firms. These ETFs hold a basket of investment-grade or below investment-grade “junk” bonds as defined by credit ratings agencies.
Overall, investment-grade corporate bonds have been a good place to hide and even profit. This is especially true right now, as market uncertainty has pushed Treasury yields down below 3%. Investors can find attractive yields in the corporate bond space.
Further strengthening the case: high-quality corporate debt has significantly outperformed equities in recent months, and corporate bonds are considered safer than common stocks since bondholders receive priority over stockholders in the event of bankruptcy.
One risk to be mindful of, however, is the influx of corporate bonds as corporations restructure and renew debt. This could lead to an oversupply that would result in prices stagnating or falling.
There’s a caveat, though: with high yields comes high risk. Junk bonds are more likely to default and their prices are closely tied to the corporations that issue them. Picking out individual junk bonds is more like speculation. That’s why investing in junk bond ETFs helps mitigate risk by holding a large pool of junk bonds within the fund’s portfolio.
International Sovereign Debt
International sovereign debt ETFs can be beneficial if you want greater diversification. International bond ETFs come in both developed market and emerging market flavors. Sovereign debt is debt issued by a national government.
With all the financial problems hovering over the eurozone, emerging market debt may look like a better alternative due to their rapid economic growth. Furthermore, emerging market sovereign debt also helps diversify a portfolio.
Still, when considering an international bond ETF in either developed or emerging markets, it is important to look at country risk, or the economic, political and business risks that are unique to a specific country or region.
Financially stronger economies will obviously provide more reliable investments than weaker ones. Additionally, political decisions may result in unanticipated losses if the political climate turns adverse to foreign investors. It is also important to factor in the credit ratings of the issuing countries.
Emerging markets offer a mix of sovereign, municipal, corporate and structured debt in either local currency issues or issues denominated in U.S. dollars or another developed currency. However, emerging markets are also riskier than developed markets due to greater political uncertainty and volatile boom and bust economic cycles.
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