Build your income strategy with Municipal Bond ETFs

• Municipal bonds (“munis”) are issued by state and local governments to fund essential projects like roads, schools, and hospitals.
• The income generated by muni bonds is often exempt from federal—and sometimes state—taxes, as a result, they can be especially advantageous for investors in high tax brackets and in taxable accounts.
• Investors can use exchange-traded funds (ETFs) to easily access the municipal markets and can customize their exposure depending on whether they seek broad or state-specific munis, short to long-term maturities, and across different levels of credit risk.

Municipalities, such your state, city, county or local agency, finance their operations through a mix of tax revenues and bonds issued to the public. By buying a municipal bond (“muni”), investors make a loan to the relevant government entity in exchange for regular interest payments and the promise of receiving their principal back at maturity. Governments issue these bonds to fund various public projects, including highways, hospitals, schools, and water systems, among others.

Munis fall into two main categories: General Obligation (GO) Bonds and Revenue Bonds. GO Bonds are backed by the full taxing power of the issuing government and are typically considered safer because the issuer can raise taxes to meet obligations. Revenue Bonds are secured by revenues from a specific project, such as income from public utility or toll collections from a highway or a bridge. Revenue Bonds may offer higher yields than GO bonds to offset the greater credit risk of the project failing to generate income as expected.

The primary appeal of munis to most investors is likely their tax advantage. The interest income paid by munis is typically exempt from federal income tax,¹ and if investors buy bonds issued by their home state or city, they may also be exempt from state and local tax.

Exchange-traded funds (ETFs) have made it easier for more investors to buy municipal bonds. Muni ETFs provide the low cost, liquidity investors have come to expect from ETFs, along with potential tax efficiency advantages² relative to mutual funds, as well as exposure to the tax-exempt income associated with muni bonds. Municipal ETFs typically seek to pay monthly income. There are over 160 muni ETFs listed in the US, representing over $200 billion in assets under management (AUM).³

 

As noted above, a main reason for municipal bonds’ appeal to investors is likely their tax advantages. The extent of those advantages is worth considering. Municipal bond yields may look lower than the yields of Treasuries or corporate bonds at first glance, but investors run the risk of missing the potential benefits if they don’t calculate the after-tax return.

As illustrated below, suppose a hypothetical taxable corporate bond yields 4.5% and a municipal bond yields 3.50%. 

Assuming an investor’s federal tax rate is 40.8%, their after-tax yield on the corporate bond is calculated as follows: 4.5% x (1-0.408) = 2.84%.⁴

In this example, on an after-tax basis, the muni bonds yield more because investors generally keep the full 3.5%, on a U.S. federal income tax basis.

It is for this reason that the tax-equivalent yield is typically quoted for munis. The tax-equivalent yield is the yield a taxable bond would need pay to match the muni’s tax-free return. Using the earlier numbers, the tax-equivalent yield on the municipal bond is calculated as 3.5% / (1-0.408) = 5.91%. In other words, a muni yielding 3.5% is equivalent to a taxable bond yielding 5.91% for someone in the 40.8% bracket. In high-income tax states like California, New York or New Jersey, the benefit of the tax exemption is even greater when state taxes are considered.

In today’s market environment, the tax-equivalent yields of certain municipal bond sectors compare favorably to taxable bond sectors. For example, the tax-equivalent yield on the iShares National Muni Bond ETF (MUB), which seeks to track the ICE AMT-Free US National Municipal Index – a broad benchmark representing the investment-grade U.S. municipal bond market – exceeds both broad U.S. Treasuries and investment grade (IG) corporate bonds (see below).

There are a multitude of choices available to investors when considering investments in municipal bonds, especially with the advent of ETFs and the wide variety of funds on offer. Let’s consider some of the main building blocks investors can use to construct a municipal bond portfolio.

Building Block 1: Geographic exposure - National vs. state-specific

Muni investors can consider choosing between bonds issued by the state in which they reside and/or national municipal bond funds or ETFs for broader exposure across states.

Investors should consider the benefits of the state and local tax exemption against the potential yield and diversification benefits that may come from a broader, national approach.

Investors in high-tax states typically get greater benefit from investing in-state, potentially drawing benefit from federal, state, and local tax exemptions. However, in low- or zero-income tax states, investors may not capture significant additional state and local tax advantages from holding state-specific bonds and may instead consider the diversification benefits of a national muni bond ETF.

Funds to consider: iShares National Muni Bond ETF (MUB) or iShares New York Muni Bond ETF (NYF), iShares Short-Term California Muni Active ETF (CALI)

Building Block 2: Duration - Short or long?

Similar to other fixed income securities, a municipal bond’s sensitivity to changes in interest rates is measured through its duration. Duration is defined as the change in value of a bond in response to a 1% change in interest rates. Generally, when interest rates have risen, prices typically have fallen, and vice versa. Municipal bonds with longer maturities generally have greater interest rate risk, and as such can have greater price swings.

Investors have sought the low or negative correlation that bonds have at times exhibited with equities as a source of diversification in their overall investment portfolios.⁵ In stock heavy portfolios, holding bonds with longer duration may be a source of potential offsetting return when stocks sell off. Many investors may not be willing to take this risk though and some may prefer to keep their duration shorter. Investors can also target intermediate duration or combine portfolios with shorter- and longer-dated bonds to seek blended outcomes, based on their risk tolerance and investment goals.

Funds to consider: iShares Short Maturity Municipal Bond Active ETF (MEAR) or iShares Long-Term National Muni Bond ETF (LMUB).

Building Block 3: Investment grade or high yield?

Another key type of risk in fixed income investing is ‘credit risk’ – the risk associated with the creditworthiness of a given issuer. This risk applies to municipal bonds, just as it does with corporate bonds. Investors seek greater compensation – in the form of yield – in exchange for buying the debt of a riskier municipality or project.

Like other fixed income securities, municipal bonds often come to market with an assigned credit rating from major agencies, which investors can leverage in their assessment of the bonds. Muni bonds with higher credit ratings have often offered lower yields than munis with lower credit ratings. Notably, the vast majority of high yield municipal bonds have come to market without a rating.⁶  Investors should consider the potential that muni bonds could lose value. Losing value is not always a result of “credit risk” as there could be an instance of a strong credit rated project has complications and cannot meet its obligations. While municipal defaults have been rare and have tended to be less frequent than those of corporate bonds,⁷ there are notable past examples such as Puerto Rico and the city of Detroit.⁸

Funds to consider: iShares Short-Term National Muni Bond ETF (SUB) or iShares High Yield Muni Active ETF (HIMU)

Building Block 4: Where to Hold Municipal Bonds?

Finally, an important consideration for investors is where to hold their municipal bonds. Knowing why you hold them answers where to hold them. Because the primary appeal of municipal bonds is their tax-exempt income, investors have historically held them in taxable accounts, where the tax benefit can be fully realized. When municipal bonds are held in tax-advantaged accounts such as 401(k)s or traditional IRAs, the tax exemption may be less impactful, as these accounts already offer tax-deferred growth. By contrast, these tax-advantaged accounts are often used for taxable bonds, such as Treasurys or corporate bonds, where interest income would otherwise be taxed annually but can instead grow tax-deferred.

It is also important to understand what role munis play in an investor’s portfolio before selecting a specific exposure. The three typical roles of bonds in a portfolio are to diversify equity risk, preserve capital, or to generate income, and different exposures serve each of these purposes better, as illustrated in the diagram below.

No bond fund can do it all. Since your municipal bonds can play a variety of roles in your portfolio, consider your desired outcome, then optimize your bond mix based on your broader asset allocation.

Municipal bonds can be high quality investment assets that can offer stability, improved tax advantages and diversification to a portfolio. They may make sense for high-income investors in higher tax brackets, and residents of high-taxes states such as California, New York or New Jersey. They could be a core fixed income holding for such investors in their taxable accounts.

As outlined throughout this article, investors can mix and match building blocks — from geographic exposure and duration to credit quality and account placement — to construct a muni allocation to pursue their goals. For a comprehensive look at the full menu of iShares municipal bond ETFs available across these dimensions, see our muni bond ETF product brief.