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- For clients who want or need a bond allocation in their taxable accounts, municipal bonds can help balance equity risk and preserve wealth.
- Short- and limited-term municipal funds can be good vehicles for additional yield for clients who already have enough cash-equivalent instruments.
- Municipal funds, whether index or active, offer several advantages over holding individual municipal bonds, including broader diversification and less cash drag.
This article originally appeared in ETF Perspectives, our quarterly publication designed to deepen your understanding of the ETF industry, with analysis from Vanguard's in-house research team and industry leaders on nearly every aspect of ETFs. View our last four editions here.
Funds focused on investment-grade municipal bonds that offer tax-exempt income can serve a variety of clients and purposes in taxable accounts. And now, to make the investments more accessible, some firms, including Vanguard, offer municipal bond ETFs.
For clients who want or need a bond allocation in their taxable accounts, municipal bonds can help balance equity risk and preserve wealth, said Fran Kinniry, a principal in Vanguard Investment Strategy Group.
High-quality,1 broadly diversified investment-grade bond funds typically do best among the major asset classes at diversifying equity risk. When stocks go down, municipal bonds can serve as ballast in a portfolio. Meanwhile, tax-exempt bonds offer a relatively attractive tax-adjusted yield compared with corporate bonds and U.S. Treasuries, Kinniry added.
"Many investors, I find, look at their bonds in isolation and their stocks in isolation. But they should look at how their asset classes fit together," Kinniry said. "Some may say, 'I want to go for higher yield in bonds.' Yet those high-yield bonds correlate more closely with the equity market than with investment-grade bonds. Looking at bonds in isolation may lead you to something that's lower in credit quality."
High-net-worth clients, who may have as much or more money in taxable accounts as in tax-preferred accounts, should consider investing in index-based equity funds as a tax-efficient position in those taxable accounts. Then municipal bonds can be used to balance those holdings, Kinniry said.
For any investor
But municipal bond funds can play a large role for any client who has reached a savings goal—whether for retirement, college tuition for the client's children, or a down payment on a house—and may need a relatively safer investment.
"There is a lot of research out there on behavioral finance, and the perceived utility of gain versus the perceived utility of loss. Most clients feel loss is more painful than the value they can gain," Kinniry said. "Thinking about wealth preservation versus growth is a good exercise to go through."
The best advice is to hold any money that is going to be needed over the next 18 to 24 months in money market funds, Kinniry said. He noted that many clients stockpile far more than that in cash instruments because of an overabundance of caution.
"Many people carry cash they don't need anytime soon," he said. "You can pick up yield by going to a short- or limited-term municipal bond fund. It's a good conversation for an advisor to have: Do you have too much in cash-equivalent instruments?"
Emotional versus actual value
Municipal bond funds come with some advantages over holding individual municipal bonds, Kinniry added.
A common technique employed by advisors is to buy individual municipal bonds and create a ladder of staggered maturity dates. Advisors sometimes consider owning individual bonds safer, based on the belief that if interest rates rise, the client will not lose money because he or she can hold the bond to maturity and get the principal back.
But Kinniry said that strategy comes with some drawbacks.
"Getting par back is an emotional value, not an actual value," he said. "The individual bonds, if marked to market, would show similar losses. While getting the principal back at maturity, the client is giving up the higher yields. So in the end, there is no economic benefit."
Also, Kinniry noted, if interest rates rise, the client will be locked into lower-yielding bonds, and he or she may not have enough from interest income to reinvest in the next bond, a problem known as cash drag. A municipal bond fund may take a temporary hit on net asset value if interest rates rise, but it will be reinvesting in higher-yielding bonds.
In addition, a municipal bond fund offers a cost-effective vehicle to invest in a broadly diversified group of bonds.
"A fund holds a large number of securities, often across the maturity spectrum," Kinniry said. "By contrast, it's very expensive to buy individual municipal bonds for the average investor. There is a lack of price transparency and discovery in the municipal market. People building ladders may not be paying commission, but they're paying it in markups. Their total return will be negatively affected by the price they pay for individual municipal bonds."
Advisors can obtain the benefits of municipal bond funds in either active or index products, including ETFs, Kinniry said. He noted that some advisors may not be able to access certain active funds on their trading platforms, so the arrival of municipal bond ETFs solves that problem.
Once advisors, and clients, choose the asset class, then they need to decide whether to use active or index options, whether to choose a fund based on duration, and whether to use a national fund or one that offers tax-exempt income for a particular state.
"The details and context matter," he said. "There's nothing at all wrong with active management, no matter if it's in municipal bonds, taxable bonds, or equities. The only reason that most active managers underperform is because they charge too much. Costs, diversification, and people are going to be the drivers there. Both active and passive are viable solutions."
1 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.
• All investing is subject to risk, including possible loss of principal.
• Diversification does not ensure a profit or protect against a loss.
• Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
• Although the income from municipal bonds held by a fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
• Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.