Fixed-income investors who follow the benchmark Barclays U.S. Aggregate Bond Index may be missing out on the stability and yield opportunity found in municipal debt securities. Consequently, traders should consider including a muni bond exchange traded fund to round out their investment portfolios.
Muni bonds help diversify a fixed-income portfolio and augment yields for those in the highest income bracket. The Barclays U.S. Aggregate Bond Index, a widely observed fixed-income benchmark, along with other broad aggregate bond indices focus on U.S. Treasuries, mortgage-backed securities and investment-grade corporate debt but would exclude municipal debt, which have historically provided lower correlations to both equities and other fixed-income assets. Consequently, investors should look to a muni bond ETF to complement an existing core bond position.
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Since municipal bond interest is exempt from federal taxes, muni ETFs are also a good way for investors to generate tax-exempt income, especially those in higher tax brackets. Because the debt category enjoys a tax-exempt status, investors would maximize the benefits of muni exposure in taxable accounts.
The tax-exempt status has made munis popular among high-income investors, so the perceived bond yields are usually lower than their taxable counterparts. For example, the iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB), the largest muni-related ETF, has a 1.32% 30-day SEC yield but that comes out to a 2.33% taxable equivalent 30-day SEC yield for those in the highest income bracket.
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Looking ahead, as the U.S. economy continues to improve, the ongoing growth growth in personal, corporate and sales tax will help bolster state finances. The prolonged low-interest rate environment has also helped support the muni market, even in the face of some high-profile defaults, such as Puerto Rico’s recent default on $422 million in Government Development Bank debt. Munis have strengthened every month this year, only the second time this has occurred since 1999.
[related_stories]Supporting the muni market, S&P Global Ratings has upgraded more localities than it has lowered for 13 straight quarters, the longest streak since 2001. S&P said it upgraded almost twice as many issuers as it downgraded in the fourth quarter last year. Fitch Ratings also pointed out that positive outlooks are the highest since at least 2001. Meanwhile, only nine issuers have defaulted in 2016 apart from Puerto Rico, compared to 24 over the same period last year.
Moreover, foreign central banks zero or negative interest rate policies are acting as a tide that lifts all boats. As international policy makers push down bond yields, yield-starved foreign investors have turned to relatively more attractive options in U.S. markets, which may include municipal bonds. Even if the foreign investors don’t benefit from the U.S. tax code, the 1.55% yield on national 10-year AAA-rated munis is still much more attractive than the 0.12% yield on 10-year German Bonds and negative -0.12% yield on 10-year Japanese Government Bonds.
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Investors interested in taking on muni bond exposure have a number of options available. For instance, MUB and Vanguard Tax-Exempt Bond Index Fund (NYSEArca: VTEB) both track the same benchmark S&P National AMT-Free Municipal Bond Index, which is comprised of investment-grade muni debt. The benchmark largely holds state tax-backed, utilities and transportation securities, with a major tilt toward California and New York debt, which make up over 40% of the funds. VTEB shows a 1.49% 30-day SEC yield.
A long-term muni fund like the VanEck Vectors AMT-Free Long Municipal Index ETF (NYSEArca: MLN) comes with a more attractive 2.46% 30-day SEC yield, but it is exposed to greater interest rate, with an effective duration of 10.61 years – a 1% rise in interest rates could translate to about a 10.61% decline in the fund’s price. MLN is less top heavy in California and New York exposure, and the ETF includes less state and local tax-backed debt.
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Investors interested in tapping into the muni bond market can also look to the Deutsche X-Trackers Municipal Infrastructure Revenue Bond Fund (NYSEArca: RVNU), an efficient way to invest in long-term, investment-grade U.S. tax-exempt munis with dedicated revenue streams, or those that have been issued with the intention of funding projects such as water and sewer systems, public power systems, toll roads, bridges, tunnels, and many other public use projects, as opposed to tax-backed debt that has attracted greater attention due to some high-profile state defaults. RVNU shows a 2.95% 12-month yield.
Lastly, muni investors can also squeeze out greater returns through high-yield options, like the VanEck Vectors High Yield Municipal Index ETF (NYSEArca: HYD) and SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEArca: HYMB). HYD has a 4.04% 30-day SEC yield and HYMB has a 3.82% 30-day SEC yield. However, the attractive payouts come with higher risks. Both funds include large speculative-grade debt allocations. HYD has 33.1% investment-grade munis, 45.7% non-investment grade and 21.2 non-rated. HYMB holds 33.5% investment grade, 45.1% speculative grade and 21.4% non-rated.