Municipal bond exchange-traded funds (ETFs) provide investors with diversified access to the municipal bond market. Municipal bonds, or munis, are debt instruments issued by states, municipalities, or counties for the purpose of financing public capital expenditures, such as the construction of highways, bridges, and schools. For investors, munis generally offer tax-free interest income. While many of these bonds are rated "investment grade" by ratings agencies, indicating a relatively low degree of credit risk, they are not risk-free. The perceived risk of munis was heightened last year amid the COVID-19 pandemic, which placed enormous financial strain on state and municipal budgets. The Federal Reserve took measures early in the pandemic in order to help calm the municipal bond market. Now, demand for munis is soaring as investors are on the hunt for yield and tax advantages, which is pushing down borrowing costs for state and local governments to near-record lows. A municipal bond ETF can help to reduce risk through holding debt issued by a broad range of states, municipal governments, or agencies.

Key Takeaways

  • Municipal bonds dramatically underperformed the broader market over the past year.
  • The ETFs with the best 1-year trailing total return are FMHI, HYMB, and SHYD.
  • The top holdings of the first two of these ETFs are bonds issued by the Buckeye Ohio Tobacco Settlement Financing Authority, and the top holding of the last ETF consists of bonds issued by the Florida Development Finance Corp.

There are 40 distinct municipal bond ETFs that trade in the U.S., excluding inverse and leveraged ETFs, as well as funds with less than $50 million in assets under management (AUM). Municipal bonds, as measured by the Bloomberg Barclays Municipal Bond Index, have underperformed the broader market with a total return of 5.8% over the past 12 months compared to the S&P 500's total return of 47.8%, as of May 17, 2021. The best-performing municipal bond ETF for Q3 2021, based on performance over the past year, is the First Trust Municipal High Income ETF (FMHI). We examine the top 3 best municipal bond ETFs below. All numbers below are as of May 18, 2021.

First Trust Municipal High Income ETF (FMHI)

  • Performance over 1-Year: 19.0%
  • Expense Ratio: 0.55%
  • Annual Dividend Yield: 3.03%
  • 3-Month Average Daily Volume: 35,189
  • Assets Under Management: $207.8 million
  • Inception Date: Nov. 1, 2017
  • Issuer: First Trust

FMHI is an actively-managed ETF that seeks to provide investors with income exempt from federal taxes as well as long-term capital appreciation. The fund invests 80% or more of its net assets in municipal debt securities that make interest payments that are exempt from regular federal income taxes. It invests in municipal bonds with a range of maturities but its largest exposure is in bonds with between 15 and 20 years remaining to maturity. The state whose bonds receive the largest exposure in the fund is Colorado. The fund's top three holdings include bonds issued by the following entities: the Buckeye Ohio Tobacco Settlement Financing Authority; the state of Illinois; and the New York City Transitional Finance Authority.

SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB)

  • Performance over 1-Year: 16.9%
  • Expense Ratio: 0.35%
  • Annual Dividend Yield: 3.44%
  • 3-Month Average Daily Volume: 186,448
  • Assets Under Management: $1.6 billion
  • Inception Date: April 13, 2011
  • Issuer: State Street

HYMB tracks the Bloomberg Barclays Municipal Yield Index, which is a market value-weighted index that gauges the performance of high-yield municipal bonds issued by U.S. states, the District of Columbia, U.S. territories and local government agencies. High-yield bonds, also referred to as "junk" bonds, pay higher interest rates than investment-grade debt due to lower credit ratings. But they are riskier investments with a much higher chance of default. HYMB invests in a range of high-yield municipal bonds with an average maturity of 14.92 years. Its top three holdings include bonds issued by the Buckeye Ohio Tobacco Settlement Financing Authority, and two different sets of bonds issued by the Puerto Rico Sales Tax Financing Corp.

VanEck Vectors Short High-Yield Municipal Index ETF (SHYD)

  • Performance over 1-Year: 16.5%
  • Expense Ratio: 0.35%
  • Annual Dividend Yield: 2.99%
  • 3-Month Average Daily Volume: 100,813
  • Assets Under Management: $314.8 million
  • Inception Date: Jan. 13, 2014
  • Issuer: Van Eck Associates Corp.

SHYD tracks the Bloomberg Barclays Municipal High Yield Short Duration Index, which is designed to measure the overall performance of the U.S. dollar-denominated, high-yield, short-term, tax-exempt bond market. The ETF focuses on high-yield municipal bonds with shorter duration, making its performance less sensitive to changes in interest rates. It invests in bonds with various maturities but its largest exposure is to bonds with 7-10 years remaining to maturity. The fund's top three holdings include bonds issued by the Florida Development Finance Corp., the Puerto Rico Sales Tax Financing Corp.,and the Illinois Finance Authority.

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