When we speak with advisors and investors, we often learn they invest in municipal bond mutual funds and ETF’s. No wonder people think municipal bonds have unattractive yields. Mutual funds and ETF’s as vehicles to invest in municipal bonds does not calculate in our minds. Why would investors and advisors give up yield and income benefits provided by individual bond portfolios? The most likely reason is advisors do not have the time or enough familiarity with municipal bonds. Clients shouldn’t sacrifice their returns and wealth accumulation possibilities (nor should they take extra risk by reaching for yield and income). A moderate duration exempt municipal bond portfolio can provide compelling yield and income with a stellar track-record of preserving capital. While some funds and ETF's will tout high yields and income levels, those are typically comprised of longer duration, lower quality portfolios, sometimes with leverage. This is not ideal for most municipal bond investors.
Individual municipal bond portfolios appear to be a better approach. They provide important advantages within the key measures of yield, income, and credit quality. A significant source of individual bonds' additional yield originates from the secondary municipal bond market’s inefficiency. When attractively positioned bonds are identified by our team of portfolio managers and traders, we aim to extract additional value by bidding on odd-lot pieces. While nearly every municipal bond fund and ETF participates in the secondary market, their enormous asset levels preclude them from deriving nearly as much value for their portfolios as compared to our clients' relatively smaller portfolios. This is one of the few areas in financial markets where a smaller investor has a larger advantage. Other advantages include our lack of reliance on pricey new deals, our ability to customize mandates for each clients' state tax exemption, and our efforts to identify attractive relative values in structures that a mutual fund or ETF may not be permitted to hold buy because they are heavily benchmark driven. We are client-driven.
Below we compare 3 popular intermediate municipal bond mutual funds and ETF’s with individual municipal bonds we prefer. The advantages are significant: the list of our individual bond choices offer more yield and income with less duration.
The above bonds provided 77 bps of additional yield over these mutual funds and 53 bps over the ETF’s. Individual bonds exhibited only 58% of the duration of the funds and just 51% of the ETF's. Individual bonds' coupons averaged 4.13% compared with the ETF’s 2.42% distribution yield and the mutual funds’ 2.78%. Another safety advantage: the mutual funds and ETF's had 11% and 6.6%, respectively, in BBB and weaker rated bonds while our selection is 100% rated A - AAA.
With this 53-77 bps yield pickup provided by individual municipal bonds in mind, we calculated the advantage of earning 1/2 percent additional yield:
Mutual Funds and ETFs vs Individual Bond Portfolios
The notion that municipal bond mutual funds and ETF’s offer compelling combinations of yield, income, and duration compared to individual bond portfolios is one to which we do not subscribe. We have experienced otherwise for years. In the above example, earning 3.00% yield versus 2.50% yield would generate an incremental $109,000 over 15 years. Most would find that impressive considering we are discussing only ½ percent total return. One-half percent or more incremental yield can often be found through a combination of bond selection, custom after-tax return focus, and the secondary market's odd-lot inefficiency.
Individual bonds offer other significant advantages as well. They are far more effective at matching every investors’ particular needs for income, state tax exemption, and yield. Bonds can provide more peace of mind because investors own securities which mature at par (a source of calm during volatile times as compared to owning the "NAV" of a fund or ETF). Another taxation benefit is important as well beyond the tax-exempt income advantages: individual bonds can be sold to realize tax harvesting benefits at year end.
Municipal bond mutual funds and ETF’s are useful when investing smaller dollar amounts and as a placeholder while you actively build bond portfolios. We suggest and urge investors to utilize individual bond portfolios to realize their many benefits when possible. Investors would be far better served from yield, income, duration, and customization perspectives.
If you invest in mutual funds and ETF's for municipal bond allocations and want to explore our ability to improve yield and income levels with less duration, please contact us. We sub-advise municipal bond portfolios for financial advisors and manage private portfolios for individual investors.
- Greg Lavine, CFA, CFP®
- Sample municipal bonds exhibiting relative value priced with Bloomberg BVAL 10/2/18. Equal weight par value: 117023BB6; 3431363Y1; 414009GP9; 41401PBX0; 438689JG7; 442435K36; 46256QDJ2; 46613CN43; 546415L40; 51856CAR2; 507207DZ8; 546589UJ9; 591745M50; 65821DFT3; 682001CA8; 691879FS4; 76222RMU3; 837542EX3; 821697G31; 821532MJ4; 833085G31; 833085T45; 880064N30; 93974C6U9; 952718UV4. 2. Equal blend VWITX, MDNLX, and PMNIX as of 9/24/18.
- Equal blend ITM, MUB, and VTEB as of 9/24/18.
Past performance is not indicative of future results.