There are many ways to access this asset offering tax-free income
Municipal bonds are looking attractive as traders remain hopeful for interest rate cuts, but investors will find that there are multiple ways to get into this income-generating asset class. Muni bonds are beloved by wealthy investors because they offer income that’s free of federal taxes. Further, investors who reside in the state where the bond was issued receive income that’s exempt from state taxes. These bonds are also due for some price appreciation once the Federal Reserve begins dialing back interest rates, a boon for investors who are already holding them in their portfolios. “With rate cuts delayed rather than canceled, we believe that yields on quality municipal bonds look attractive at current levels,” wrote Kathleen McNamara, municipal strategist at the chief investment office, Americas, for UBS, in an April 25 report. “And, there’s also potential for capital gains as the year progresses.” She noted that taxable-equivalent yields – the pretax yield a taxable bond would have to generate in order to be equal to that of a tax-free muni bond – can exceed 8% “for certain high net worth investors, suggesting a compelling opportunity.” You don’t have to buy individual munis to get into the market, though. Here are a few ways to buy in – and the pros and cons of each method. Different levels of buy-in and tradeoffs Investors hoping to tap the municipal bond market have a few questions to consider. First, how much money are they earmarking for the purchase? That’s because individual municipal bonds are typically sold in increments of $5,000, which can be a high hurdle for investors looking to build out a diversified portfolio of issues. Investors also must be willing to perform due diligence on these individual bonds. Open-ended mutual funds and exchange traded funds offer investors access to a basket of bonds, and the underlying issues come with a range of maturities and coupons – but the minimum investment may be more manageable. Consider that Vanguard’s Intermediate-Term Tax-Exempt Fund (VWITX) has an investment minimum of $3,000 and includes more than 13,000 muni bonds. It has a 30-day SEC yield of 3.46% and an expense ratio of 0.17%. Investors also need to consider their time horizon as they navigate the purchase. When an investor purchases an individual muni bond, he knows that if he holds it to maturity, he’ll get the principal back – regardless of the price whims of the bond market in the interim. Investors can also use individual issues to build out fixed income strategies. This includes bond ladders, which involve buying a portfolio with different maturities and then reinvesting the proceeds of expiring issues into new, longer-dated bonds. Muni bond ETFs and mutual funds, meanwhile, don’t have a definite maturity date and their price can fluctuate while the investor is holding them. “If you want a more diverse selection, you can consider the mutual fund or the ETF,” said Beth Foos, associate director of fixed income strategies, manager research at Morningstar. “But they can be volatile.” Liquidity needs are also a major factor, with individual bonds potentially being hard to sell if an investor has a cash need. “If you need to raise some cash and you’re liquidating before maturity, you may not get the best execution,” said James Ritzema, senior portfolio analyst at Baird. Meanwhile, investors in mutual funds and ETFs will have an easier time selling their holdings. Finally, investors can’t forget about fees. Funds with the highest expenses will ultimately take a bite out of investors’ returns. Closed-end funds Another way to get into the municipal bond space is to consider closed-end funds, which trade on exchanges like mutual funds, but offer only a limited number of shares. Since these funds offer a fixed number of shares, they trade at a discount or premium to their net asset value. They also use leverage, which can help enhance returns but also introduce some volatility. Some of these funds hold municipal bonds and are trading at sharp discounts to their net asset value, potentially making them an attractive purchase. “If the Fed reverses course and starts to cut, and if inflation remains muted … it bodes well for longer-duration asset classes,” said Jon Browne, senior investment analyst at RiverNorth. He noted that “a large number of municipal closed-end funds” are trading at double-digit discounts. Investors who participate in the closed-end funds space should be cognizant of the fund’s expense ratio, which can exceed 1%. They should also be aware of a fund’s use of leverage, which can magnify downside.
- Business
