Exchange-traded funds (ETFs) are typically used to gain diversified exposure to several securities through a single investment. Traditional stock ETFs, for example, allow investors to buy and sell a “basket” of stocks by investing in a single security. It is worth noting, however, that ETFs aren’t relegated to stocks. Funds use ETFs to invest in several types of securities, and municipal bonds are no exception. Similar to how a stock ETF may diversify an investor’s holdings within an index, a municipal bond ETF will diversify the income opportunities granted by local governments. If for nothing else, there are a lot of types of municipal bonds, and these investment vehicles allow investors to gain exposure to multiple bonds at a time.
What Are Municipal Bonds?
To truly understand what a municipal bond ETF is, investors must first familiarize themselves with the concept of a bond. Fortunately, bonds aren’t nearly as complicated as many people make them out to be. Outside of a widely used investment vehicle, bonds are essentially glorified “IOUs” distributed on behalf of governments, municipalities, and corporations. The bond represents an attempt to raise capital for a wide range of projects and ongoing expenses. In the event any one of these entities needs capital, they simply need to issue a bond. Doing so on the bond market simultaneously puts in a request for capital and awards bond investors with the opportunity to supply the funds (in exchange for earning interest on the loan).
A municipal bond is, therefore, an attempt on behalf of a local government to raise funds for a project. Whether it’s a park or a toll road, local governments may use municipal bonds to fund the project. In doing so, the government will issue bonds with a face value (the amount they hope to borrow from an investor). When an investor buys a bond at face value, the government entity agrees to pay back the same amount over a predetermined amount of time (the maturity date). In that time, the investor can expect to receive their initial investment, plus interest (also known as the coupon rate).
When all is said and done, municipal bonds enable individual investors to act as the bank for local government projects, which begs the question: What is a municipal bond ETF? Simply put, this type of ETF allows investors to diversify their municipal bond holdings on the bond market. Not unlike a traditional ETF featured on Wall Street, funds will package municipal bonds into a single ETF that investors may buy into. That way, investors may invest in a “basket” of bonds, as opposed to a single bond.
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Pros Of Municipal Bond ETFs
These types of ETFs have proven they can belong in a diversified investment portfolio. Diversification out of the stock market and into income-generating assets is a great hedge for investors nearing retirement However, these particular investment vehicles are just that: particular. Municipal bond ETFs offer very specific advantages that may not be suited for every investor’s needs. As a result, it’s important to look at what municipal bond ETFs have to offer, and whether or not they meet the needs of individual investors. Here’s a list of the benefits investors can expect to partake in when they invest in municipal bond ETFs:
Diversified Access: As exchange traded funds, municipal bond ETFs give investors diversified access to the municipal bond market. Instead of investing in a single bond, investors may invest in a basket of stocks. In doing so, investors may not only diversify their exposure to bonds issued in various states, but also different payment intervals and coupon rates.
Tax-Free Dividends: Provided the bond investor is a resident in the issuing state, income generated from municipal bonds in the form of dividends is usually exempt from state and federal taxes. To be clear, the interest income generated is tax-exempt, but any realized capital gains may be subject to subsequent taxes.
Monthly Returns: While there are exceptions, most municipal bonds pay their coupon rate (or interest) every month to the bondholder. As a result, bond investors can expect a relatively safe, stable income over the course of the bond’s maturity date.
Low Volatility: The highest-rated bonds, like those backed by the U.S. government (or local governments), promise to return the principal investment by the maturation date. Investors can expect at least some level of capital preservation. That said, not even municipal bonds are immune to volatility entirely. The Coronavirus, for example, has thrown share in the direction of municipal bonds, as it has made it harder to pay back bonds in the face of financial hardships.
Low Risk: Bonds have developed a reputation for being less risky than traditional stocks. The fixed income generated from bonds is usually less sensitive to the macroeconomics of the U.S. economy, whereas stocks have proven volatile over short periods of time.
Cons Of Municipal Bond ETFs
Not unlike every investment opportunity, municipal bond ETFs coincide with both risks and rewards. In addition to the benefits listed above, investors also need to be aware of the drawbacks associated with investing in municipal bond ETFs:
Low Rate Of Return: Municipal bond ETFs are considered relatively “safe” investments. However, in exchange for safety, investors are also accepting a limited upside. Since bonds are one of the safest investments out there and even a hedge against a volatile stock market, returns are relatively low. As a result, this isn’t so much of a drawback as it is the cost investors pay for safety.
Not All Returns Are Tax Free: More often than not, the income generated in the form of interest from municipal bond ETFs is tax free. That said, there are exceptions. In particular, some scenarios will call for income to be taxed if it falls under the alternative minimum amount (AMT). In the event income generated from a municipal bond ETF doesn’t meet the AMT requirements, investors may have to pay taxes on it.
The 3 Best Municipal Bond ETFs Of 2021
Much like their stock counterparts, the returns associated with these ETFs are directly correlated to performance; that is to say, some municipal bond ETFs perform better than others. Over the course of 2021, in particular, these are the best municipal bond ETFs:
IQ MacKay Shields Municipal Insured ETF (MMIN)
Invesco Taxable Municipal Bond ETF (BAB)
IQ MacKay Shields Municipal Intermediate ETF (MMIT)
IQ MacKay Shields Municipal Insured ETF
The IQ MacKay Shields Municipal Insured ETF, otherwise known as MMIN, seeks to generate income for investors which is exempt from federal income taxes. Actively managed, the IQ MacKay Shields Municipal Insured ETF does not attempt to replicate a single market’s performance, but rather invests in bonds which will help it meet its own benchmark. In doing so, 80% of the ETF’s funds are reserved for investing in debt securities. With most of its assets in investment-grade municipal bonds, contributors can rest assured they will receive their principal and interest payments.
Invesco Taxable Municipal Bond ETF
The Invesco Taxable Municipal Bond ETF prioritizes Build America Bonds (hence the ticker BAB). As their names suggest, Build America Bonds were introduced in 2009 in an attempt to initiate a recovery out of The Great Depression. The bonds created jobs and stimulated the economy up until 2010, and are still paying coupon rates to this day.
IQ MacKay Shields Municipal Intermediate ETF
Not unlike the first ETF on this list, the IQ MacKay Shields Municipal Intermediate ETF focuses on a collection of investment-grade bonds. What’s more, the fund is actively managed to reach its own benchmark, and not mimic the current bond market. In doing so, the IQ MacKay Shields Municipal Intermediate ETF tries to maintain a dollar-weighted average over the course of anywhere from three to 10 years.
The Best High-Yield Municipal Bond ETFs
To be clear, municipal bond ETFs reward investors with a relatively low yield compared to their traditional stock market counterparts. However, there are some standouts within this sector. Here are some of the best high-yield ETFs investors should consider:
SPDR Nuveen Bloomberg Barclays High Yield Municipal Bond ETF (NYSEARCA: HYMB)
VanEck Vectors High-Yield Municipal Index ETF (NYSEARCA: HYD)
VanEck Vectors Short High-Yield Municipal Index ETF (NYSEARCA: SHYD)
SPDR Nuveen Bloomberg Barclays High Yield Municipal Bond ETF
The SPDR Nuveen Bloomberg Barclays High Yield Municipal Bond ETF seeks to reward investors with income based on bonds issued by U.S. states, the District of Columbia, U.S. territories and local governments or agencies. Year-to-date, the total return is -0.97, but 2021 has been anything but normal. The yield, however, is a promising 3.77%.
VanEck Vectors High-Yield Municipal Index ETF
The VanEck Vectors High-Yield Municipal Index ETF, originally created in 2009, seeks to base its performance off of the Bloomberg Barclays Municipal Custom High Yield Composite Index.
VanEck Vectors Short High-Yield Municipal Index ETF
The VanEck Vectors Short High-Yield Municipal Index ETF hopes to mimic the results of the Bloomberg Barclays Municipal High Yield Short Duration Index. The Bloomberg Barclays Municipal High Yield Short Duration Index tracks high-yield, short-term, tax-exempt U.S. dollar-denominated municipal bonds. However, in the wake of the Coronavirus, the fund has underperformed in 2021. Year-to-date returns are -1.02%, but the overall yield is still attractive to investors.
The concept of a municipal bond ETF works a lot like a traditional exchange traded fund on Wall Street. However, instead of dealing in stocks, municipal bond ETFs deal in debt securities issued by local governments. Therefore, investors contributing to a municipal bond ETF can increase their exposure to the bond market and diversify their holdings. Doing so may simultaneously hedge against a volatile stock market and ensure income for those on the brink of retirement. All things considered, there are few investments that help investors avoid as much risk as muni bonds, which is why these investment vehicles are primed for those in the latter stages of their investment careers.
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