We previously highlighted the basics of municipal bonds and their potential benefits to investors. The next question is, how do you actually get exposure to munis? Individual bonds? Mutual funds? ETFs? Which way is best? Ultimately, that depends on the investor.
The advantages of individual bonds
One advantage of individual bonds is the ability to control interest rate risk. Currently, a major concern for bond investors is low interest rates. Paltry bond yields mean less income and perhaps more importantly, if rates rise, the market value your bond portfolio declines. To lower potential interest rate risk, one option is to build an individual bond “ladder” with staggered maturities every year. When the bonds mature in a theoretical higher rate environment, the bonds can be reinvested at higher rates.
In addition, shorter maturity bonds will decline less than longer maturity bonds, helping insulate the portfolio from the damaging effects of rising rates. Another advantage to laddering is customizing cash flow. Some investors want a predictable cash flow stream of monthly income and predetermined maturities. Laddering individual bonds can help accomplish that.
Another advantage of individual bonds is the state tax exemption. There are several good national muni bond ETFs, however there are advantages to constructing a portfolio of individual bonds to reduce state income taxes. Investors can avoid paying taxes on interest by owning tax exempt munis issued within their state of residence. If you live in a less populated state like Missouri or Kansas, there are only one or two mutual funds and no ETFs that hold munis exclusively from those states. Big states like California and New York have many fund options. A few states have no state income taxes, so issuer state isn’t a concern for those residents. State specific mutual funds for smaller states typically have high fees, along with elevated interest rate risk. For a Missouri resident, a portfolio of individual Missouri tax exempt munis saves paying the 5.4% state income tax on coupon income and also avoids the high fund fees and excessive interest rate risk.
The advantages of ETFs and Mutual Funds
Constructing a portfolio of individual bonds isn’t for everybody. It requires specific knowledge of where to find the bonds, due diligence on the issuers, and managing transaction costs. Municipal ETFs and mutual funds are a convenient option for those who wish to avoid navigating the ins and outs of muni markets. Mutual funds have traditionally dominated the fund space and there are some good options, however, high fund fees can be a concern. Muni ETF fees are often lower and the universe of ETF options is rapidly expanding. ETFs can also offer tax efficiency, transparency, and liquidity advantages over mutual funds.
Municipal bonds are popular with fixed income investors because of their potential tax benefits, diversification, and income generation. The highest quality munis have lower default risk than some types of corporate bonds, particularly junk rated bonds. Understanding key differences between the various ways to gain exposure to this unique segment of the market can help investors select the right muni bond options for their portfolios.
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Brian Murray MBA, CFA is an Investment Advisor at The ETF Store. He has 23 years of experience as a fixed income portfolio manager for multibillion-dollar institutional portfolios. He helped develop the fixed income department at a $55 Billion investment advisory firm where he managed hundreds of portfolios for individual investors.