Alternative Ways to Gain Municipal Bond Exposure

We've been covering municipal bonds, with a focus on markups, this week on the blog. So far we've discussed some basics, given an example of an excessive markup and introduced SLCG research on excessive markups in municipal bonds . Given that retail investors may be charged excessive markups when purchasing municipal bonds directly, it may make sense for them to purchase municipal bonds indirectly.

Jason Zweig has written a great follow-up to his coverage of the muni markups issue with a rundown of alternatives for municipal bond investors. These alternatives include municipal bond mutual funds, closed-end funds, as well as exchange-traded funds and could lead to potentially lower transactions costs.

Currently, the three largest municipal bond mutual funds (by total fund assets) are:¹

1. Vanguard Intermediate-Term Tax-Exempt Fund (VWITX): 0.20% expense ratio
2. Vanguard Limited-Term Tax-Exempt Fund (VMLTX): 0.20% expense ratio
3. Franklin California Tax-Free Income Fund (FKTFX): 0.57% expense ratio, 4.25% front-end load/sales charge

The three largest municipal bond ETFs are:

1. iShares S&P National AMT-Free Municipal Bond ETF (MUB): 0.25% expense ratio
2. SPDR Nuveen Barclays Short Term Municipal Bond ETF (SHM): 0.20% expense ratio
3. SPDR Nuveen Barclays Capital Municipal Bond ETF (TFI): 0.23% expense ratio

Finally, the three largest municipal bond closed-end funds are:

1. Nuveen Municipal Value Fund (NUV): 0.40% six-month average discount
2. Invesco Municipal Opportunity Trust (VMO): 0.17%six-month average premium
3. BlackRock Municipal Target Term Trust (BTT): -1.26% six-month average discount

Jason points out that mutual funds and exchange-traded funds "can buy wholesale while individuals have to buy retail, which typically is more expensive." The EMMA data does not distinguish between retail and institutional transactions (the distinction is only the size of the trade), but in percentage terms larger trades tend to have smaller markups. In addition, investors in funds can buy and sell their shares at effectively any time with low trading costs, so unless an investor is set on holding a municipal bond to maturity, the liquidity of a bond fund could be a major advantage over holding an individual bond directly.

While even no-load mutual funds and exchange-traded funds have expense ratios, those expenses tend to be small, and may be compensated for by the diversification benefits of a large fund. FINRA's Investor Alert on municipal bonds notes that municipal bond portfolios should be diversified in a variety of ways:

When diversifying within the muni bond asset class, consider diversification by issuer, location and maturity date. One way to diversify your municipal bond holdings is by investing in a municipal bond mutual fund or municipal security ETF. Be sure to research the securities in a given mutual fund or ETF, as well as maturity lengths (longer maturities usually mean greater risk). Be aware that bond funds and ETFs may invest in a narrow group of holdings (only tax-deferred bonds, for instance) and so your diversification may be limited. Bond funds and ETFs can decline in value, and prices fluctuate. Read the prospectus carefully before investing.

Vanguard also has a paper that describes the advantages and disadvantages of holding municipal bonds directly. They point out that holding individual bonds does give the investor increased control, but usually at the cost of "higher (or additional) transaction costs, lower liquidity, more limited return opportunities, and higher risks." It may be the case that only sophisticated investors, who would place a high value on the control aspects of individual bonds and could diversify those positions themselves, would be better off buying individual bonds rather than bond funds.

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¹Fund rankings are based upon total assets given by Bloomberg, LP using the <FSRC> function. In each of these cases, there is more than one fund class that can be purchased. As noted to the lower right, inclusion of any particular fund in this or any post should not be considered an endorsement or investment advice.