April 15 came and went, but the memory of how much of your pay the Internal Revenue Service helped itself to should remain clear. As should the realization that you probably should have done more to limit your tax burden.
One way for wealthier investors to reduce their tax obligations is through municipal bonds. Almost all bonds issued by local governments in the United States are exempt from federal, state and local taxes, particularly for residents of the jurisdiction issuing the bond. The logic is that it’s somewhat untoward for city hall to borrow money from people, then charge them for the privilege of having done so.
Late in 2013, the Federal Reserve announced it would begin winding down its infamous quantitative easing policy. Reducing the scope of a federal bond-buying program ought to have a predictable effect on interest rate movements, and with a new Fed Chairman taking the reins in February 2014, municipal bonds are making a comeback. But the asset class consisting of municipal bonds is so broad – ranging from junk-quality Puerto Rico Sales Tax Financing Corporation sales tax revenue bonds maturing in 2057, to California’s AAA-rated Association of Bay Area Governments Finance Authority for Non-Profit Corporations Senior and Subordinated Revenue Bonds that come due later this year – that it’s hard or impossible to suggest municipal bonds as an investment without being more specific.
The ETF Advantage
Fortunately, investment management companies are one step ahead as usual. Muni bond exchange-traded funds make it easy to stay diversified while ensuring that public works projects get funded. While we can’t predict which muni bond ETFs will be the most successful between now and when your next tax bill comes due, we can at least find some prudent and creative methods of exposing yourself to these tax-friendly investments.
One of the largest muni bond ETFs is the iShares 2017 AMT-Free Muni Bond fund (NYSE Arca:MUAF). The "2017" refers to the year its components mature. U.S. News & World Report ranked the fund 2nd among muni bond funds. It barely fluctuates more than 1.5% in either direction, which is what you hope for in a muni bond ETF. The fund holds 527 bonds from all but three states. No one bond comprises more than 0.85% of the total. The smallest of those components each make up less than 0.004% of the fund’s net asset value, which could make one wonder if there’s such a thing as too much diversification.
What makes a good ETF? Obviously, returns, but that’s too vague an answer for too general a question. It’s not that hard to find a penny stock that’s up 2,000% in the past year, but such a stock wouldn’t exactly fit the definition of a “good” investment: among other problems, the likelihood of future price increases is slim. If we’re serious about looking at investments, rather than vehicles for speculation, we can define a well-performing ETF as one that:
· Beats other ETFs with a similar objective,
· Has a low expense ratio.
Sure, some analysts look at other criteria: Diversification is a favorite. But as a look at the makeup of almost any ETF would verify, we’re approaching the limits on how eclectic ETFs can be.
Buy Based On Objective
When assessing and comparing, the objective of the ETF is critical. If you want your ETF to possibly increase in value (or risk losing your shirt), buy a leveraged-equity ETF. As for muni bond ETFs, again, people don’t invest in them for capital appreciation. Muni bond ETF investors are looking for someplace safe to put their money. A 1% gain or even a 1% loss beats a 35% tax levy. In other words, we can ignore “beats other ETFs with a similar objective” as a criterion when determining what constitutes a good muni bond ETF. If you need proof, understand that the best-performing muni bond ETF over the past year - the iShares Short-Term National AMT-Free Muni Bond (NYSE Arca:SUB) - has returned a whopping 0.97% to its holders in that period. Its closest competitor has returned 0.62%.
When a paltry 0.35% is enough to separate the highest-performing muni bond ETF from the next, that should tell you two things. First, that we’re dealing with exceedingly small differences in this particular subclass, and second, that expense ratios now become everything. With the exception of one outlier, expense ratios among municipal bond ETFs operate in a predictable range. Some investment management companies charge 0.35%, others 0.2%, most somewhere in between. Given that the difference between the expense ratios of the "economy" muni bond ETFs and those of their free-spending, high-overhead brethren is so large (relative to the difference in returns among muni bond ETFs), the correct but colorless recommendation is to buy the muni bond ETF with the lowest expense ratio. There are four with expense ratios of 0.2%:
· SPDR Nuveen Barclays Capital Muni Bond (NYSE Arca:TFI)
· SPDR Nuveen Barclays Capital Short-Term Muni Bond (NYSE Arca:SHM)
· SPDR Nuveen S&P VRDO Municipal Bond (NYSE Arca:VRD) (VRDO stands for variable-rate demand obligations, meaning that the interest rate resets periodically and that the holder can cash out at par).
· Van Eck Short Municipal Index ETF (NYSE Arca:SMB)
The Bottom Line
You won’t get rich on muni bond ETFs. Their advantage lies elsewhere. The important thing to remember is that the taxes on any of the above muni bond ETFs remain a cool 0%. Let the IRS get its pound of flesh elsewhere.