An Effective Way To Broad Municipal Bond Exposure

While the Federal Reserve waited until December to raise interest rates, fixed income investors used the first 11 months of 2016 to warm to municipal bonds and the related exchange-traded funds.

The popularity of municipal bond ETFs further underscores investors' desired for income and yield while highlighting the belief that many bond investors believe state and municipal balance sheets are in solid shape. Additionally, the tax-exempt status of municipal bonds makes the asset class a favorite among retirees and investors nearing retirement.

ETF MUB Benefits From Tax-Exempt Status

The iShares S&P Natnl AMT - Free Munpl Bd Fd MUB is among the ETFs benefiting from those themes. MUB follows the S&P National AMT-Free Municipal Bond Index, which is the equivalent of a cap-weighted benchmark for an equity-based index fund. Said another way, MUB's 3,245 holdings are weighted by debt outstanding.

“Because the fund weights its holdings by the amount of outstanding debt, the portfolio skews to the most-indebted regions,” said Morningstar in a recent note. “As a result, negative regional events, such as Detroit’s bankruptcy (2013) and Hurricane Sandy (2012), can have an outsize impact on the fund’s performance. At the end of December 2016, the fund had greater exposure to California and New York than its municipal national intermediate Morningstar Category peers.”

California and New York munis combine for almost 43 percent of MUB's weight. Over the long run, assuming MUB's index weights do not significantly change, the ETF could be challenged by the myriad budget and fiscal solvency issues facing California and New York, including abilities to cover pension funding, short obligations or sudden spikes in demand for services.

Four states — Montana, North Dakota, South Dakota and Wyoming — are not represented in MUB's lineup. Unfortunately for MUB and its investors, North Dakota and South Dakota are two of the most fiscally solvent states in the country.

Risks And Rewards

Still, in MUB's favor is a lack of credit risk and an effective duration of less than 6.3 years, putting in the middle of the interest rate risk spectrum.

“The fund’s geographic risk is partially offset by its relatively conservative and diverse portfolio. More than 80 percent of the fund’s assets are invested in securities rated AA or above. Most peers take greater credit risk, though it has a similar interest-rate risk profile to the category average. The resulting portfolio offers a lower yield to maturity than the category average. In addition, it doesn’t invest in bonds issued by U.S. territories, including Puerto Rico, and spreads its risks across more than 3,000 holdings,” added Morningstar.

Investors added $2.44 billion to MUB last year.