Municipal bonds are thought of as the sleepier corner of the fixed income universe, but 2008 brought renewed investor attention to this $2.6 trillion market. In fact, as the year came to a close, municipal bonds were trading near historically high yields versus their Treasury counterparts.
Because of their tax-exempt status, the yield on a national, investment grade municipal bond has typically been about 85 percent to 90 percent of the Treasury equivalent. As of last December, long-dated muni's with a triple-A rating traded at an unprecedented 100 percent or more of taxable equivalents. An investor in the 35-percent federal tax bracket would earn a yield advantage in excess of 30 percent over 10-year treasuries.
With bonds available from more than 60,000 state, local and agency issuers, the municipal bond market is notoriously inefficient when it comes to building a portfolio. Achieving proper diversification is a challenge for all but the savviest individuals, while illiquidity and wide spreads on bid and ask prices for individual bonds drive up the costs of execution. Yet as boomers age, they'll increasingly seek ways to generate safe, after-tax income. Fortunately, new financial products are emerging that will help advisors meet this need. Foremost among these is municipal bond exchange-traded funds.
ETFs are gaining favor with advisors, who have been quick to recognize their many benefits, including liquidity, transparency, low costs and the ability to use sector-specific ETFs to build a broadly diversified portfolio. More recently, ETFs have begun to make inroads in fixed-income, including municipal bonds, and the benefits they offer are much the same with the added bonus of tax-free monthly dividends. This benefit will be even more pronounced should marginal tax rates rise under an Obama administration.
But advisors should note that even clients in the lower tax brackets (a group that includes many retirees) can still enjoy the benefits of muni investing. Take, for example, an investor with income taxed at the 15 percent level, currently the lowest federal tax bracket. An investment grade intermediate portfolio yielding 4.5 percent would deliver income equivalent to that of a taxable bond yielding 5.29 percent, currently 175 percent above the yield on 10-year Treasuries.
While individual bond purchases of under $1 million may have bid-ask spreads of $1 to $3 per $100 of face value, muni ETFs trade like a stock with average bid-ask spreads of about .3 percent in the first 11 months of 2008. As with other ETFs, muni exchange-traded funds are designed to replicate as closely as possible the performance of an underlying index. Yet, there are no guarantees that replication can be achieved. Given the sometimes murky world of municipal bond trading, the challenge for sponsors is to find or develop indexes that provided sufficient diversification and liquidity to meet the demands of cost-efficient daily trading. New indexes and innovative sampling techniques allow muni's to now participate in the ETF universe.
The timing is right for muni ETFs because total costs -- not just expense ratios -- become more significant for fixed income products in a lower interest rate environment. Most municipal bond mutual funds have average expense ratios in excess of 60 basis points, and embedded costs from buying or selling bonds for cash could conservatively add another 10 basis points of performance drag. Conversely, muni ETFs have average expense ratios of 20 basis points. More significantly, ETFs often transact with qualified institutional investors via a barter-like or "in-kind" exchange of bonds for ETF shares. The net cost savings to ETF investors may average at least 50 basis points. That differential, compounded over time, represents a significant advantage in overall return.
Michael Mazier and Jim Colby are part of the investment team responsible for Van Eck Global's investment products, including Market Vectors municipal bond investments. For more information, visit vaneck.com.
