Municipal bonds have been a stellar asset class over the past year. In fact, the iShares S&P National AMT-Free Municipal Bond Fund (MUB) outperformed the S&P 500 SPDR (SPY) by over 5% between January 13, 2015 and January 12, 2016. Muni bonds could continue to outperform in fixed-income markets throughout 2016 given their tax-advantaged nature, attractive yields, and high credit ratings relative to corporate bonds.
Investors looking to buy into the muni bond market have two options: they can purchase individual muni bonds or purchase bond funds that hold diversified portfolios.
Are Bonds Less Risky?
Many investors believe that individual bonds are less risky than bond funds because individual bonds can be held until maturity. After all, you’ll never lose more than you invested in absolute terms with an individual bond unless the bond defaults. Bond funds, by contrast, could depreciate in value over time during periods of rising interest rates. These arguments may sound logical, but they fail to hold up when doing the math.
Individual muni bonds and bond funds are subject to the exact same term structure of interest rates used to determine their prices. Since bond funds offer forward rates associated with a longer maturity, they may actually return more than individual bonds over time. Individual bonds do not provide any kind of special interest rate protection over bond funds when investing in lower-duration funds that match the comparable individual bond.
Economies of Scale
Municipal bond funds take advantage of economies of scale to significantly reduce the costs associated with muni bond investing. While bond funds charge an expense ratio, the fund’s economies of scale may help increase yields to at least partially offset these costs.
Investors should consider the following benefits:
- Diversification: Muni bond funds provide instant diversification across hundreds of different bonds, whereas investors would have to purchase a number of individual bonds to achieve the equivalent level of diversification.
- Trading Costs: Muni bonds may cost more to purchase in smaller denominations with spreads differing by upwards of 1% between a $100,000 trade and a $5 million trade. This means means that bond funds can purchase bonds more efficiently.
- Liquidity: Muni bond funds can be instantly liquidated during the same or next business day, which enables investors to efficiently access their capital and rebalance their portfolios. Individual bonds can take significantly longer to sell at a good price.
Control Premiums
At the same time, individual municipal bonds do have a control advantage over bond funds, which may warrant consideration for some investors.
Bond funds don’t let investors influence the selection of bonds, which means that they may not be tailored toward individual objectives, like AMT-free income or specific state exposure. In some cases, the higher costs associated with buying individual bonds can be offset by tax savings from holding individual bonds exempt from AMT or the investor’s state income tax. However, it’s important for investors to look at after-tax returns when comparing their options.
Individual bonds also enable investors to realize losses that can be used for tax purposes, whereas bond funds compare realized gains to losses and carry forward any excess losses. In these cases, investors should consider the fact that they can sell a bond fund to realize losses and the transaction costs must be factored into any tax savings. It’s also worth noting that bond funds utilize any losses to improve long-term tax efficiency to the fund’s structure.
The Bottom Line
Municipal bonds can be purchased individually or through muni bond funds. In general, muni bond funds provide greater benefits to individual investors, but there are instances where individual muni bonds may be advantageous to own. Investors should carefully weigh these choices when making a decision to avoid any unnecessary costs.
