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 or equity. However, it is worth noting 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 Bond ETFs?
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. If 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. Local governments may use municipal bonds to fund the project, whether it’s a park or a toll road. 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). During that time, the investor can expect to receive their initial investment plus interest (also known as the coupon rate).
Municipal bonds enable individual investors to act as the bank for local government projects, which begs the question: What is a municipal bond ETF? This type of ETF allows investors to diversify their municipal bond holdings in 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 they meet individual investors’ needs. Here’s a list of the benefits investors can expect to partake in when they invest in municipal bond ETFs:
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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.
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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. The interest income generated is tax-exempt, but any realized capital gains may be subject to subsequent taxes.
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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.
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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 shares in the direction of municipal bonds, as it has made it harder to pay back bonds in the face of financial hardships.
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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.
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:
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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.
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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). If income generated from a municipal bond ETF doesn’t meet the AMT requirements, investors may have to pay taxes on it.
Top 10 Municipal Bond ETFs Of 2022
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 2022, in particular, these are expected to be the best municipal bond ETFs investors can add to their portfolios:
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IQ MacKay Shields Municipal Insured ETF (MMIN)
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Invesco Taxable Municipal Bond ETF (BAB)
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IQ MacKay Shields Municipal Intermediate ETF (MMIT)
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SPDR Nuveen Bloomberg Barclays High Yield Municipal Bond ETF (NYSEARCA: HYMB)
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VanEck Vectors High-Yield Municipal Index ETF (NYSEARCA: HYD)
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VanEck Vectors Short High-Yield Municipal Index ETF (NYSEARCA: SHYD)
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Invesco VRDO Tax-Free ETF (NYSEARCA: PVI)
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iShares iBonds Dec 2022 Term Muni Bond ETF (NYSEARCA: IBMK)
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Invesco BulletShares (R) 2022 Municipal Bond ETF (NASDAQGM: BSMM)
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Vanguard Tax-Exempt Bond Index Fund (NYSEARCA: VTEB)
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 that will help it meet its 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. Most of this ETF’s assets are allocated to the securities which comprise the ICE BofAML US Taxable Municipal Securities Plus Index. As a result, the success or failure of this ETF is dependent on the performance of U.S. dollar-denominated taxable municipal debt publicly issued by U.S. states and territories.
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 for anywhere from three to 10 years.
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 down 11.2%, but 2022 has been anything but normal. The yield, however, is a promising 3.42%.
VanEck Vectors High-Yield Municipal Index ETF
The VanEck Vectors High-Yield Municipal Index ETF, originally created in 2009, seeks to base its performance on the ICE High Yield Crossover Municipal Bond Transition Index. In doing so, this municipal bond ETF aims to invest at least 80% of its total assets in the securities which make up the index it is trying to simulate. So far in 2022, the VanEck Vectors High-Yield Municipal Index ETF has drastically underperformed the broader market, but its diversification lands it a top spot on our list. With diverse exposure and low default rates, this ETF can provide some safety at a time when the market appears to do nothing but go down.
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 2022. Year-to-date returns are down 9.4%, but the overall yield is still attractive to investors.
Invesco VRDO Tax-Free ETF
As its name suggests, the Invesco VRDO Tax-Free ETF awards investors the opportunity to collect tax-exempt yields. The tax-exempt status helps mitigate some of the risk associated with this ETF, albeit slightly. While every municipal bond ETF comes with some risk, the Invesco VRDO Tax-Free ETF is about as safe as they come. Do not expect high returns, but it may be a great place to hide money while the market figures itself out in the face of an impending recession.
iShares iBonds Dec 2022 Term Muni Bond ETF
Managed with the intentions of replicating the S&P AMT-Free Municipal Series Dec 2022 IndexTM, the performance of the iShares iBonds Dec 2022 Term Muni Bond ETF is directly correlated to investment-grade, non-callable U.S. municipal bonds which are set to mature this year. As a result, this investment has underperformed relative to its peers over the last three years. It is worth noting, however, that low returns are partially offset by a low expense ratio. The 1.19% yield looks a lot better when fewer annual fees are deducted annually.
Invesco BulletShares (R) 2022 Municipal Bond ETF
The Invesco BulletShares (R) 2022 Municipal Bond ETF attempts to replicate the performance of Invesco BulletShares USD Municipal Bond 2022 Index. Not unlike the other ETFs on this list, this particular investment will invest at least 80% of its total assets in municipal bonds that make up the Invesco BulletShares USD Municipal Bond 2022 Index. As a result, this ETF directly correlates with the performance of a portfolio of U.S. dollar-denominated, issued by U.S. state, state agencies, or local governments with effective maturities in 2022.
Vanguard Tax-Exempt Bond Index Fund
The Vanguard Tax-Exempt Bond Index Fund is another option for investors to collect tax-exempt yields. In managing bonds from issuers whose interest is generally tax exempt, the Vanguard Tax-Exempt Bond Index Fund may pass on the benefit to its investors. In return for the tax-exempt status of its yield, however, the Vanguard Tax-Exempt Bond Index Fund has relatively average return rates. With a yield of 1.75%, investors will use an ETF like this more as a shelter.
Summary
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, few investments 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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