By Tyler Denholm, TOPS ETF Portfolios
As managers of ETF portfolios for 15 years, we have witnessed significant development in the ETF world. There are areas like S&P 500 exposure and gold, where ETFs have staked claim as the go to tool for access. However, there are other areas like fixed income where the surface is just being scratched. We feel, with some development and innovation, the fixed income space may be the fuel for another $1 Trillion in ETF assets.
One particular area of opportunity for ETFs is municipal bonds. Municipal bonds may be one of the most powerful tools to provide income for high-earning clients. The potential for triple tax free income (federal, state and local) provides a benefit that other fixed income products cannot match and the comparative benefit improves as the client’s tax bracket increases. As portfolio managers, we often utilize municipal bonds as a potential way to optimize risk adjusted after tax return for our investors.
While we manage a significant amount of individual bond issues, this article will focus on the different ways to access the municipal bond market through exchange traded funds (ETFs).
Municipal Bond ETF Landscape
While not the most robust offering in the entire ETF landscape, there are still over 35 different municipal bond products, covering a multitude of different segments. The first muni bond ETF offerings were the national municipal bond ETFs. These funds attempt to replicate the entire municipal bond market – they are essentially the building blocks typically used in the creation of a bond portfolio. With assets nearing $8B, the iShares National Muni Bond ETF (MUB) represents the largest of these municipal bond ETFs. No surprise, Vanguard’s Tax-Exempt Bond Index Fund ETF (VTEB) has the lowest expense ratio of any national muni bond ETF at just 0.12%.
From there, the industry diversified the ETF bond mix by adding short-term funds like SPDR’s Nuveen Barclays Short Term Municipal Bond ETF (SHM) and single state funds like iShares California Muni Bond ETF (CMF) and iShares New York Muni Bond ETF (NYF). Rounding out the coverage of broad muni bond ETFs was the launch of high yield funds like the VanEck Vectors High-Yield Municipal Bond Index ETF (HYD).
While these funds typically provided the benefits of broad diversification, both in terms of states and issuers, the biggest downsides to most the broad offerings were the inability to control your duration and the lack of a stated maturity. For most of these funds, their goal was to simply gain exposure to a broad market of municipal bond offerings. While the short-term funds like SHM did provide the ability to do some level of duration management, being able to fine tune your maturity exposure did not really exist until iShares launched iBonds in 2010.
If the broad-based funds are the blunt tool used to provide exposure to municipal bonds, then iBonds are the surgeon’s scalpel. Designed to provide precise maturity exposure, iBonds is the name given by iShares to their term-maturity fixed income ETFs. Essentially, these funds will purchase a broad mix of municipals which all mature in a set calendar year. For example, the iShares iBonds Dec 2022 Term Muni Bond ETF (IBMK) will purchase non-callable US municipal bonds maturing in 2022.
As mentioned above, a benefit of this product is the ability to fine tune the duration of a portfolio. For portfolios which already contain the broad municipal bond ETFs, duration can be lowered through the implementation of term-maturity ETFs that are maturing the next few years. Keep in mind that as time marches forward to the maturity date, the manager may need to role these products to keep the duration at a targeted level. Likewise, recognize products with a stated maturity inherently carry additional reinvestment risk.
Opportunity to Ladder Bonds with ETFs
For retirees, the construction of a bond ladder is an attractive asset management tool. By building a ladder, clients can lock in their yield and have a known income amount for each year. The challenge with individual bond ladders is the minimum amount needed to construct a diversified portfolio.
Our typical recommendation for clients is to have at least $500k to invest in a bond ladder to get proper diversification amongst issuers and maturities. With iBonds typically trading around $25 per share, you could build a bond ladder for a fraction of what an individual bond ladder would need. The downside to iBonds is that you cannot get single states and the maturity schedule currently goes out to just 2022. Therefore, if an advisor has a client who would benefit significantly from the state tax deduction, they may only receive a fraction of the income generated from ETF as tax free. Likewise, if the advisor wants to build a longer ladder, the max maturity is limited to just 5 years from today.
Innovation and Adoption Needed
In summary, we can continue to see product innovation across multiple segments of the ETF industry, but particularly in the fixed income markets. Future innovation may include additional single state bond ETFs, longer dated iBonds or a new way to slice and dice the asset class with a new surgical tool. If the ETF industry and investors continue to support an active marketplace for target maturity municipal bond ETFs, we feel these tools can take significant market share from traditional active municipal bond funds. They are a better design, just need better overall adoption. Regardless, there are currently many ways to provide tax-advantaged income to high-earners within the world of muni ETFs.
This article was written by Tyler Denholm, CFA, who is Vice President – Research & Investments at TOPS ETF Portfolios, a participant in the ETF Strategist Channel.
Important Disclosure
IBMF, IBMG, IBMH, IBMI, IBMJ, IBMK, MUB, SHM have been, may be and/or are currently held in several TOPS portfolios.
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