Municipal bonds have been strong performers this year, despite troubles in Detroit and Puerto Rico, thanks to record low interest rates that led investors to seek yield. With the Federal Reserve expected to hike interest rates in December, many experts believe that bond prices are likely to fall as yields rise. Municipal bonds may be a bit more robust than the average bond – due to their tax-advantaged nature – but investors may still have to be selective.
In this article, we’ll take a look at some of the top municipal bond funds to consider in 2016, given these evolving dynamics.
Playing It Safe
The State Farm Municipal Bond Fund (SFBDX) provides investors with broad exposure to bonds with income that’s exempt from Federal income taxes. With long-term maturities and at least 70% of its assets in A-rated or better bonds, the fund returned 2.44% over the last year and ranked in the top 17% of its category. The below-average 0.15% expense ratio also limits the amount that investors are paying to management and improves relative returns.
While the muni bond fund may be immune to high-yield issues, investors must still worry about the impact of rising interest rates, especially given the longer duration of its holdings. Investors may be getting a comparative advantage relative to traditional long-term bond funds, due to the tax advantages, but the fund may still suffer on an absolute basis from rising rates. Some of these risks could be mitigated by laddering with other bond funds.
Going Short
The Vanguard Limited-Term Tax-Exempt Fund (VMLTX) provides the same tax advantages as the State Farm fund but has shorter durations that may suffer less from rising interest rates. With an expense ratio of just 0.2% and an average duration of about two years, the fund is one of the cheapest options in its asset class and returned 1.12% over the past year, placing it in the top 20% of funds in its category in terms of performance.
Since short-term bond prices tend to fall less than long-term prices when interest rates are on the rise, investors in this fund may be better positioned to weather the Federal Reserve’s rate hike than other muni bond funds. The fund also still realizes the same tax benefits as longer-term muni bond funds since it holds tax-advantaged bonds in its portfolio, which means that investors have a comparative advantage to traditional bond funds.
Climbing the Ladder
Investors may also want to consider building a laddered municipal bond portfolio using either individual bonds or exchange-traded funds (ETFs). With iShares’ iBonds ETFs, the process of creating these ladders may be a bit easier for individual investors looking for diversified exposure to municipal bonds at a reasonable buy-in cost. Many individual municipal bonds, after all, have relatively high minimum purchase requirements.
iShares provides a number of target-date municipal bond ETFs to do so:
- iShares 2016 S&P AMT-Free Muni Series ETF (IBME)
- iShares 2017 S&P AMT-Free Muni Series ETF (IBMF)
- iShares 2018 S&P AMT-Free Muni Series ETF (IBMG)
- iShares 2019 S&P AMT-Free Muni Series ETF (IBMH)
- iShares 2020 S&P AMT-Free Muni Series ETF (IBMI)
Investors looking to build their own portfolio can purchase different allocations of each of these funds in order to customize their exposure. For instance, an investor that believes rates will rise may weight nearer-term ETFs higher while putting less capital into longer-dated funds.
The Bottom Line
The municipal bond market was a strong performer this year, but these trends are likely to change over the coming year amid higher interest rates. Investors may want to consider these three strategies when building their exposure moving into 2016.
