Using Muni ETFs to Complement a Portfolio of Bonds

For municipal bond investors, life has gotten more difficult — not less:

• Persistent low rates have driven some investors to take on more concentrated duration or credit risk than they may be comfortable with (or should be comfortable with) or hold fewer bonds.
• Lingering concerns about creditworthiness have been compounded in some cases by an increase in political risk and as a result, an issuer may have the ability to pay its debt but may be less willing to do so.
• Drastically reduced secondary market liquidity has made it more difficult (and expensive) to be nimble. In order to protect themselves should the need arise to sell bonds prior to maturity, some investors have restricted themselves to only the largest and most liquid bonds available, thereby limiting their ability to pursue incremental yield opportunities.
• The dynamics of muni bond supply and demand are subject to seasonal imbalances, and this year the supply of new issue bonds is down over 8% versus 2015, while the upcoming “Summer Redemption Season” is expected to add over $100 billion in redeemed municipal bond principal to reinvestment demand, according to Bloomberg data.

Given these challenges, investors may wish to consider whether using muni bond ETFs as a complement to an existing portfolio may be easier and more efficient than using individual bonds as a way of maintaining an appropriate asset allocation mix and risk profile.

Because muni ETFs are managed to maintain a constant duration, the decision to reinvest can be made when it makes the most sense for each investor’s goals—not just because bonds are maturing.

For example, many investors have used a laddered portfolio strategy (in which equal amounts of principal are divided across sequential maturities) as an interest rate neutral way to manage their portfolio. (Interest rate neutral refers to the fact that a laddered portfolio favors neither a rise nor a fall in rates, as opposed to other strategies that may favor one interest rate environment over another.)

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Because a laddered portfolio has principal maturing on a regular basis, the investor is tasked with the need to reinvest the matured principal in order to keep the money working. If an investor’s bonds are maturing in June, July, or August of this year, he may find himself competing against other investors for the limited supply of good quality and liquid bonds available in the market.

A muni ETF may make sense as a short-term holding to maintain asset class exposure until a suitable replacement bond is found, or the ETF can be used as a longer term holding, replacing the matured “rung” on the portfolio ladder.

The easy to access intra-day liquidity for muni ETFs has attracted a variety of market participants who are not active in the underlying over-the-counter market for individual bonds. As a result, fluctuations in investor demand may not have as much of an effect on the volume of ETF trading as it may in the cash market.

Post Disclosure

Patrick Luby is a Fixed Income Portfolio Strategy Specialist and the author of www.IncomeInvestorPerspectives.com. He has been helping many of the industry’s best advisors and their investor clients understand and navigate the municipal bond market since the weekly Bond Buyer Municipal Bond Index was at 9.48%.

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.