Why Individual Municipal Bond Portfolios?

When we speak with investors and advisors, we often learn they rely heavily on municipal bond mutual funds and ETF’s. To that we say, “no wonder people think municipal bonds are expensive!” This widespread reliance on mutual funds and ETF’s of municipal bonds does not calculate in our minds. Why would investors and advisors give up yield and income benefits provided by individual bonds at the same time they face generationally low municipal bond yields? Investors shouldn’t have to sacrifice yield and income in this low rate environment, nor should they take unnecessary risk with “safe” bond portfolios by reaching for yield and income. We feel there are better approaches.

Individual municipal bond portfolios appear to be a better approach. Individual bonds can provide advantages including additional income and yield. A significant source of additional yield originates from the secondary municipal bond market’s inefficiency. When attractively positioned bonds are identified by our team of asset managers and traders, we can extract additional value by bidding on odd-lot pieces in the secondary market. 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 from odd-lots as our clients. This is one of the areas on “Wall Street” where the smaller investor has a larger advantage.

Below we compare 2 large intermediate municipal bond ETF’s and mutual funds with municipal bonds we recently placed in client portfolios. The advantages were significant: these individual bonds offered more yield and income with shorter duration and zero management fees.

The above bonds provided 88 bps of additional yield over mutual funds and 63 bps over ETF’s. Individual bonds exhibited 62% of the duration of the ETF’s and 72% of the mutual funds. The bond coupons averaged 4.08% compared with the ETF’s 2.2% distribution yield and the mutual funds’ 2.8%. The final glaring advantage: ETF expense ratios average 0.25% above and the mutual funds’ average 0.45% while the bonds have no fee.

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.

Individual bonds offer other significant advantages. Bond portfolios are far more effective at matching investors’ needs for income, taxation, and yield. Bonds provide peace of mind because investors own securities which mature at par (a source of calm during volatile times as compared to investing in the NAV of a fund or ETF). Another taxation benefit must be considered as well, beyond the exempt income benefit -- individual bonds can be sold to realize tax harvesting benefits.

We are not suggesting investors eliminate municipal bond mutual funds and ETF’s from their portfolios. Municipal bond mutual funds and ETF’s are useful when investing smaller dollar amounts and as a place-holder while you actively build portfolios. We do suggest and urge investors to utilize individual bond portfolios to realize their myriad benefits. Investors would be far better served from yield, income, duration, and customization perspectives.

As asset managers and traders, we position our clients uniquely close to the municipal bond market. Please contact us to learn how we can help you build individual bond portfolios.

Greg Lavine, CFA, CFP®

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