How to decide when to invest in municipal bonds versus new tax-efficient bond ETFs that don’t invest in munis.
We analyze several newer ETFs that earn bond-like returns while avoiding paying taxable income distributions.
Investments mentioned:
- Vanguard Tax-Exempt Bond ETF (VTEB)
- iShares 7-10 Year Treasury Bond ETF (IEF)
- JPMorgan Ultra-Short Municipal Income ETF (JMST)
- Alpha Architect 1-3 Month Box ETF (BOXX)
- F/m Compoundr U.S. Aggregate Bond ETF (CPAG)
- F/m Compoundr High Yield ETF (CPHY)
- NEOS Enhanced Income Aggregate Bond ETF (BNDI)
- NEOS Enhanced Income 1–3 Month T-Bill ETF (CSHI)
Show Notes
US municipal bond defaults and recoveries, 1970-2022 by Moody’s Investor Service—Fidelity
Five Reasons Municipals Have Rarely Defaulted by Matthew Norton—Bernstein
Cboe:BOXX | Investment case—alpha architect
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 540. It’s titled “Beyond Munis: New ETFs for Tax-Efficient Bond Investing.”
I recently received an email from a Plus member who is early retired. They have about two-thirds of their assets in tax-deferred vehicles such as IRAs and 401ks, and one-third in taxable accounts. Their taxable accounts, at least as of early this year, was 100% in stocks, but their goal is to shift more of the taxable accounts to bonds, while also keeping it tax-efficient.
Municipal Bond Investing
Now, in earlier episodes, such as our bond master class that I’ll link to in this episode, we talked about the logical solution. If you want tax-efficient bond investing, own municipal bonds. Municipal bonds are bonds issued by states and municipalities. They’re exempt, in most cases, from federal taxes, and potentially state taxes if you own municipals from your home state.
One benefit of municipal bonds is their default rates have been extremely low; much lower than investment-grade corporate bonds, or clearly non-investment-grade corporate bonds. Now, we’re talking about investment-grade municipal bonds, because there are also non-investment-grade municipal bonds that have higher default rates. We’re not discussing those today. But if we look at the cumulative five-year default rate for municipal bonds overall, 0.18%. That’s very, very low.
There are two types of municipal bonds. There are general obligation bonds that are backstopped by the full faith and credit of the issuing government, and there are revenue bonds that are backed by fees from public service enterprises, like utilities, toll roads, airports. One reason that municipal bond default rates are so low is that these municipalities, these government entities, they have the power to tax and to raise fees. And so that gives them the ability to service the debt.
There are also oftentimes reserve funds and other mechanism to make sure that these municipal bonds get serviced first, that the interest and principal payments are made, and default rates are very low.
An example of a way to invest in municipal bonds is the Vanguard Tax-Exempt Bond ETF (VTEB). Its SEC yield is 3.5%. Now, we have to keep in mind that we’re not paying federal income tax on these municipal bonds or that ETF, like you would if you owned a taxable bond fund like the Vanguard Total Bond Market ETF (BND).
So what we can do with a municipal bond or a municipal bond ETF is to convert it to its tax-equivalent yield. And we do that by taking the yield and dividing by one minus the highest marginal tax rate of that investor.
So if the investor is in a 35% marginal income tax bracket, we can take that 3.5% yield and divide it by one minus 35%. That equals 65%. So essentially, we’re taking 3.5% divided by 0.65, and that gets us a tax-equivalent yield of 5.4%. That’s attractive. That’s more than you can get right now with BND, which has a pre-tax yield of just over 4%.
But not everybody’s in the 35% tax bracket. What if you’re in the 22% tax bracket, the highest marginal tax rate for many retirees? And so if we divide that 3.5% SEC yield by one minus 22%, that gets us 4.5% tax-equivalent yield, which is a little closer to overall bonds such as the Bloomberg Aggregate Bond Index, or ETFs that track that. Now, the duration or interest rate sensitivity of VTEB is 7.3 years, which is fairly long. If interest rates go up 1%, this ETF’s price could fall by 7.3%.
A comparable ETF with a similar duration would be the iShares 7-10 Year Treasury Bond ETF (IEF). It has a duration of 7.04 years, and its SEC yield is 3.9%. We already saw the tax-equivalent yield for VTEB for someone in that 35% tax bracket is 5.4%, so that’s better than comparable Treasury ETFs. And if the investor is in a 22% marginal income tax bracket, it was 4.5%, which is still higher than the 3.9% on a similar duration ETF. But not everyone wants to take that type of interest rate risk.
What if you want to invest in shorter term municipal bonds, such as the JP Morgan Ultra Short Municipal Income ETF (JMST)? It has a duration of 0.7 years. Its SEC yield is 2.6%, and its tax equivalent yield at a 35% tax bracket is 4%, and at a 22% tax bracket, it’s 3%.
So not as attractive on a tax-equivalent basis. In fact, a 3% tax-equivalent yield for that investor in a 22% marginal tax bracket—that’s less than you can get in cash. And so that investor would be better off investing just in a traditional money market fund or short-term Treasury ETF, and they would have a higher yield, even after paying taxes than they would investing in a shorter-term municipal.
And that’s the thing with muni bond investing—sometimes yields on muni bonds are so low that it doesn’t make sense to invest in them, even if you’re at that higher tax bracket. At other times, the yield on munis is much higher, and it makes sense even at lower marginal income tax rates.
One way to avoid the interest rate sensitivity issue of munis is what many of our Plus members do, is they buy individual municipal bonds and hold them to maturity, and they lock in the yield that they get at the time that they bought that particular bond.
Now, that takes work, you have to diversify, but the fact that default rates are so low, we can get some comfort level for buying a general obligation bond. You live in California and buy a California state bond, or—it’s certainly doable. It’s easier to do than trying to select individual non-investment grade corporate bonds, or even corporate bonds, because of the much lower default rate for municipal bonds.
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