In the recent financial crisis, equity markets experienced huge capital outflows, which caused panicked investors to scramble for investment safe havens. Although municipal debts provide predictable returns, these securities also carry their own risks, including credit risk, interest-rate risk, liquidity risk and poor transparency. The question investors must ask is, “Should I opt for specific individual muni bonds or should I mix and match individual bonds of different flavors to diversify my portfolio and meet my specific risk-return profile?”

In this article, we’ll attempt to shed some light on the current market conditions for fixed-income securities and how they impact your individual municipal debt holdings. Also, we will explore various aspects of muni exchange-traded funds (ETFs) to provide a logical investment rationale and exemplify the conditions under which potential investors might consider muni ETFs as better investment solutions.

In the last couple weeks the U.S. Treasury yield curve flattened, primarily due to the rise of short-term rates and an approximately 10 bps decline in the mid- and long-term rates, particularly for 20- and 30-year treasuries. This occurred after an increase in the federal funds rate, a trend likely to continue in the coming months given relatively good economic growth, employment statistics and an increase in private-sector wages.

Now, an investor holding an individual municipal bond with longer duration has no options other than to hold the bond until maturity or sell it at a discount in the secondary market. Along the same lines, demand for short-term tax-exempt muni bonds has risen during the same time. Individual muni bond investors, often holding a limited amount of securities, face more of the concentration and interest-rate risk due to lack of diversification. In case you want to know more, you can read what higher interest rates really mean to bondholders and how, as a bondholder, you can estimate your interest-rate risks.

If individual munis aren’t the answer, how can fixed-income investors mitigate their risk in today’s environment of rising interest-rate expectations?

Just like a mutual fund, a bond ETF is an investment vehicle, but it’s traded like a stock. An average ETF has a core strategy to handle the securities it holds. For instance, bond ETFs are likely to only hold bonds. So, instead of holding one muni bond exposed to substantial credit and interest-rate risk, one can partially mitigate these risks through an ETF by holding several bonds. Moreover, an investor can own hundreds of bonds within an ETF at a purchase price significantly lower than what it would cost to own all the same bonds individually.

ETFs have been pretty common for equity investors. However, with the recent instances of municipality bankruptcies and difficulties in meeting pension obligations, bond ETFs, including those incorporating muni bonds, have emerged as a safer bet to investing in individual muni bonds. In this context, you can explore our Muni Bond ETF section to learn more about ETFs specializing in this space and read some of the key tips to invest in the right muni ETF.

Muni ETFs have been a great diversification tool for individual muni investors due to their ability to provide better transparency, intra-day tradability and lower costs than other types of pooled funds. However, before arriving at an investment decision, muni bond ETF investors should know of the potential risks as mentioned below.

• Principal At Risk: Unlike individual bonds, muni ETFs hardly mature. This means that there is no guarantee of you getting your money back from the investment. In an individual debt instrument, investors are able to hold their investment until maturity and get the principal back along with coupon payments. In an ETF, you are holding a “wrap instrument,” which doesn’t mean you are the actual owner of the underlying securities; thus, the principal return isn’t guaranteed. However, muni ETFs have started to emerge with a target maturity date (i.e. iBonds Dec 2021 Term Muni Bond ETF).
• Trading Costs: Although ETFs provide liquidity throughout the day because they can be traded like normal stocks, there is a trading cost associated with each buy or sell order. So, if there are muni bond investors looking to place frequent trades, ETFs may not be as cost-effective.
• Tax Considerations: Muni ETFs are known to generate tax-free (triple–tax exempt in some instances) income because of the underlying securities they hold. Muni ETFs don’t protect against capital gains taxes that are usually generated through trading profits; however, just like in equities, if an ETF portfolio holds a muni bond in its portfolio for over a year, the tax would be classified as long-term, resulting in a rate lower than the short-term tax rate.
• Interest-Rate Risk: This is one of the biggest risks for debt investors and it also applies to muni ETFs. This comes from the negative correlation between interest rates and bond values. However, if an ETF is holding a set of muni bonds with the right mix of different maturities, the interest-rate risk can be mitigated to a certain extent.
• Concentration Risk: In a national muni ETF, there could be muni securities from all around the US. While this is a good avenue for proper diversification, it can also embed concentration risk in the form of exposure to a particular sector or industry. For example: a municipality from the Midwest facing financial troubles could be a part of an ETF, subjecting you to credit risk that you otherwise wouldn’t have been exposed to.

You can explore more details about ETF risks in general. And be aware of the different types of risks that muni bonds can face.

Muni ETFs are a great tool that provides investors with wide array of options and benefits to protect their principal. Investors can further benefit if they keep the following points in mind.

Muni ETFs with alternate minimum tax (AMT) exemption provisions can further enhance returns. Investors should review their options and consult with a tax consultant on AMT-exempt ETFs (for example, consider the VanEck Vectors AMT-Free Intermediate Municipal Index ETF).

Muni bond ETFs, if offered with active management strategies at a reasonable fee, can further enhance risk-adjusted returns, mainly because of the inherent liquidity and mispricing issues.

Be sure to visit our Market Activity section to explore recent muni bond trades.

Muni ETFs are a diversification medium that can help protect your capital in changing economic conditions. However, there are risks associated with any constructed portfolio of various securities that can potentially lead to loss of capital. Investors should consider all the potential trade-offs among less expensive muni ETFs, actively managed mutual funds, and “guaranteed” coupon payments from individual munis before making their investment choices.

Check out the different ways to invest in muni bonds to stay up to date with current investment strategies.

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