Ultimate Guide on How to Invest in Municipal Bonds

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So you’ve decided you want to invest in municipal bonds but don’t know where to start? I am going to show you a few ways to add municipal bonds to your portfolio. I will assume you already know the benefits and risks of muni investing. Ultimately the way you structure your muni portfolio will be based on your personal needs.

An important reminder: Tax-exempt muni bonds receive an exemption from federal income tax on the coupon payments. This means your muni investment should be in an account that is taxable. Roth IRAs or 401ks are not the type of account you should put muni bonds in because these types of accounts are not taxable. Traditional IRA’s that you are receiving taxable withdrawals from or traditional taxable brokerage accounts that you are receiving income from are better types of accounts to use for muni investments.

The Easiest Way to Invest in Municipal Bonds

The easiest and most efficient way to invest in municipal bonds is through a fund. If are investing under $100,000 this is the probably the best way to go.

There are several types of funds including open-end funds, closed-end funds, and exchange traded funds (ETF’s).

Open-end Funds

Open-end funds – These are the most common mutual funds. One advantage is the fund does not restrict the number of shares they issue like closed-end funds. One disadvantage is your trades are based on the end of day NAV or net asset value so you can’t trade during market hours. Short-term trading is not for long-term muni investors anyway.

Here are a few examples of open-end muni funds. There are a variety of strategy based muni funds including total muni market index type funds, short duration, high yield, and state specific municipal funds.

Closed-end Funds 

Closed-end funds (CEF) – These types of funds have a limited number of shares available. When you want to buy or sell shares, you have to trade with investors just like you would for a stock. Closed-end funds trade during market hours so your trade price is not based on end of day NAV price.

In fact, one reason many investors like closed-end funds is because you can often purchase shares at a discount to NAV which means you are buying the underlying assets cheaper than their book value. This discount comes at the price of liquidity because closed-end funds require a willing buyer to sell your shares to unlike an open-end fund for which your shares are redeemed by the mutual fund when you sell.

Here are a few examples of some muni CEF’s:

  • NUV – Nuveen Municipal Value
  • NMI – Nuveen Municipal Income
  • MUI – BlackRock Muni Inter Duration
  • IQI – Invesco Quality Muni Income Trust
  • PMO – Putnam Municipal Opportunities

CEF’s often use leverage which means they borrow money to invest. This is one risk to keep in mind when investing in CEF’s because leverage increases risk. If rates rise the losses will be magnified.

Exchange Traded Funds

Exchange Traded Funds (ETF) – An ETF has some of the features of a closed-end fund and an open-end fund. These funds trade shares through an exchange just like a share of a stock would. This means the share price can become disjointed from the underlying NAV. One benefit of an ETF is they often have lower fees than their open-end fund or closed-end fund counterparts.

MUB, the iShares National Muni Bond ETF is the largest muni ETF with almost $8 billion of net assets. The fund has over 3,000 bond holdings and charges an expense ratio for just .25%.  That means to invest $100,000 in the fund it would only cost you $250 a year. It would be impossible to develop a portfolio of individual bonds for a $100,000 portfolio this cheaply when factoring in trading and execution costs.

Other muni ETF’s to consider are:

  • SHM – SPDR Nuveen Barclays Short Term Municipal Bond ETF
  • SUB – iShares Short-term National Muni Bond ETF
  • ITM – VanEck Vectors AMT-Free Intermediate Municipal Index ETF
  • VTEB – Vanguard Tax-Exempt Bond ETF

How to compare Municipal Bond Funds

If you decide to invest in municipal bond funds pieces of information to compare between the funds to decide which fund to invest in.

Fees – The expense ratio tells you how much the fund charges to manage your money. Many funds will charge a higher fee for active management while index funds charge lower fees. You want to choose a fund that has relatively low fees.

Holdings – Look at the top holdings of the fund to get an idea of what the fund is investing in. Make sure the fund invests in what they are saying the invest in. Oppenheimer has a state specific fund called the Rochester Pennsylvania Municipal Fund. based on that name, I would expect them to invest in Pennsylvania municipal bonds. It turns out about 32% of their fund is in Puerto Rico!

invest in municipal bonds

 

 

 

 

 

 

 

Source: OppenheimerFunds taken 3/26/17

The point is make sure the fund you invest in is actually investing in what you intend to be invested in.

Invest in Individual Municipal Bonds

If you have over $100,000 to invest in municipal bonds than developing a portfolio of individual municipal bonds could be a better way to do it rather than buying a fund.

Advantages of a self-constructed Muni Portfolio

Constructing your own portfolio allows you to manage duration risk, credit risk, and extension risk for callable munis to fit your own risk tolerance.

Duration risk measures the sensitivity to changes in interest rates. If interest rates go up (as they have recently with the Fed raising short-term rates), then the value of your bonds go down. By  constructing your own portfolio you can determine how much duration you want to take on.

Credit risk is the risk of the municipality not making interest payments or paying their bonds when they come due at maturity. Higher rated bonds have lower credit risk. If you are opposed to investing in certain states or territories (such as Puerto Rico), you have no control over this if you buy a fund. If you develop your own portfolio you can choose which state and local municipalities you invest in.

Lastly, most muni bonds longer than 10 years come with embedded call options. When you invest in callable bonds the structure of the call, the maturity date, and the coupon will be important depending on your view of what the interest rate curve will look like at the time of the call. Choosing a higher coupon means you pay a higher price for the bond now but it would be more likely to be called on the call date. Buying a lower coupon bonds means you pay a lower price for the bond but the bond would be more likely to extend to the maturity date rather than to be called. This is extension risk.

Disadvantages of a self-constructed Muni Portfolio

There are several disadvantages of constructing your own muni portfolio.

One of most obvious problems is time. Reviewing each municipal credit you invest in takes time. Reading the S&P or Moody’s report, reading the official statement, and reviewing the financial statements can be very time-consuming. This is especially true for new municipal bond investors who might not be familiar with the terminology.

Another disadvantage is cost. Buying a municipal bond fund can be much cheaper. As noted earlier, some of the funds have an expense ratio as low as .25%. Each individual municipal bond you trade will have costs associated with trading. Your broker will take his cut by buying the bonds cheaper than he sells them to you. If you don’t monitor your brokerage firm’s trades they could take advantage of you by charging you much more mark-up than should be charged. Keep an eye on the trade history of the bonds you buy after you buy them to see how much mark-up was in the trade. You can view trade history data through FINRA’s website.

Have questions about investing in munipal bonds?

Post your questions in the comments and I’ll be happy to answer any questions you might have.

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