Muni bond exchange traded funds (ETFs) make it easier than ever to invest in a diversified bond portfolio, but there are many important elements for investors to consider before investing in these funds to avoid potential problems.

In this article, we will look at the differences between muni bond ETFs and how to choose the right options for your portfolio.

There are more than 30 different municipal bond ETFs, ranging from the broad $7.8 billion iShares National Muni Bond ETF to the niche $1.8 million First Trust Municipal CEF Income Opportunity ETF. While these ETFs may look like equity ETFs on the surface, there are important differences under the hood in terms of how muni bond portfolios are built and valued and how dividends are paid. If you are wondering how to locate individual muni bonds from creditworthy states, you can explore our New York and California bond sections.

The major differences between muni and equity ETFs include:

• ETF composition: Most equity ETFs build portfolios that mimic an underlying index of stocks. For example, SPDR S&P 500 ETF builds its portfolio based on the S&P 500 index. Muni bond ETFs cannot mimic bond indexes as efficiently, since there’s a high cost associated with purchasing thousands of bonds in illiquid markets. Fund managers address these issues by picking securities, to include in the index, that are highly liquid representative samples.

• Liquidity and ease of valuation: The individual muni bonds underlying a muni ETF’s portfolio differ from the equities underlying equity ETFs, too. For example, the muni bond market is significantly less liquid than the equity market, making muni bonds more difficult to value. Microsoft Corp. trades nearly 30 million shares per day, whereas the entire municipal bond market can trade less than 25,000 bonds on some days.

• Income distribution: Most muni bond ETFs also pay dividends monthly rather than quarterly. For income investors, this means that muni bond ETFs can be used to generate consistent retirement income compared to traditional equity ETFs that usually distribute income every three months. However, yield calculation becomes difficult as one needs to account for more frequent changes.

Make sure to check out our Market Activity section to view the recent trading performance of individual muni bonds across the U.S.

Municipal bond ETFs can be challenging to evaluate for equity investors. Rather than focusing on valuation metrics, bond ETF investors should seek portfolios with a stable risk profile and attractive yields. Risk factors might include the bond portfolio’s aggregate credit rating and interest rate risk, which is often measured by looking at duration since shorter-term bonds tend to react less to interest rates than longer-term bonds.

In addition, investors must look at after-tax yields when evaluating muni bonds relative to conventional bonds. Most advertised after-tax yields look at the highest possible individual tax rates, whereas an individual investor’s tax rates may be lower than the highest bracket. Therefore, it’s important to calculate these yields using your own applicable tax rate when comparing muni bonds with other types of taxable bonds that could offer better opportunities.

Investors should further consider the differences between distribution yields, SEC equivalent yields, and other types of yields. The distribution yield reflects the annual yield that an investor would receive if the most recent fund distribution and current price remained the same, whereas the SEC equivalent yield looks at a fund’s yield over the past 30 days after deducting its expenses, which may or may not provide a more accurate picture.

See 3 Tips for Choosing the Right Muni Bond Fund for more insights into analyzing and selecting the best options for your portfolio.

Municipal bond ETFs face a variety of unique risk factors related to their low liquidity. For example, State Street stopped accepting cash redemption orders for its muni bond ETFs from dealers in 2013 after the market experienced a significant single-day sell-off.

Some of the unique risk factors that muni bond investors should consider are mentioned below.

• Investors can avoid these risks by looking for muni ETFs with narrow bid-ask spreads and high average daily volume.
• During troubled times, investors can look at fund flows and block trades to identify situations where large institutional investors may be trying to sell.
• Limit orders are a great way to ensure the proper price when buying or selling muni ETFs with low liquidity, which may be the case with certain niche issuers.

Municipal bonds are popular fixed-income investments during low interest rate environments, which has spawned a growing number of muni bond ETFs. When interest rates begin to rise, muni bonds may outperform other fixed income assets – since they’re tax-advantaged – but they tend to underperform equities since higher yields result in lower prices.

While these funds may appear similar to equity ETFs, there are many important differences that investors should consider. There are also several unique risk factors that could impact an investor’s risk-adjusted returns over time. By using the right strategies, investors can avoid these risks and take advantage of ETFs as an easier vehicle for building a portfolio.

Be sure to visit our Municipal Bond Investment Strategy section to keep track of important trends.