How to Manage Tax-Free Bond Portfolios More Effectively

On January 4, 2018

Even with recent tax law changes, the need for tax-exempt municipal bond portfolios remain significant.  Although the top tax bracket has been lowered to 37%, a broad high investment grade municipal portfolio can provide yields of close to 3% on a taxable equivalent basis.  Also, these securities can deliver significantly better credit diversification with an equity portfolio than corporate bonds.

Historically, municipal portfolios have been troublesome for financial advisors to manage.  Owning a set of individual bonds is very problematic:

• It is difficult to evaluate creditworthiness of individual issuers. One could buy only AAA bonds but the yields have not been attractive.
• The bid/offer spread on municipals can be very wide. This is especially true for trades of less than $100,000 par value.
• If the client is depending on interest paid to cover living expenses, the income received is “lumpy.” In other words, it is difficult to construct a portfolio of securities with consistent interest payments throughout the year.

Although owning individual mutual funds solve many of these problems, others are entailed:

• Almost all mutual funds are perpetual. Since they never mature, the fund values will vary significantly with interest rate changes.  This will become more evident as we move deeper into the secular increase in interest rates we are currently experiencing.
• An advisor can only see the holdings in the fund on a delayed quarterly basis. Intra-quarter, one does not know if the portfolio manager is increasing risk by lengthening maturities or going down in credit ratings to receive more income on a short-term basis.
• Many of these funds have high management fee. For example, the fee-waived MFS Municipal Limited Maturity Fund A shares have a fee of 80 basis points. Given the relatively low yields of short to intermediate bonds, a high proportion of income received is being reduced by fees.

Steps to Better Manage Tax-Exempt Bond Portfolios

With the advent of 21^st century investment products and processes, advisors can create municipal portfolios in a wiser manner. There are five steps to take to do so:

1. Include low-cost exchange-traded funds (ETFs) and closed-end mutual funds. Although municipal bond closed-end funds have been around for decades, the tax-exempt ETF market has blossomed in recent years. Currently, there are almost 40 funds issued by 12 ETF providers. Half of these ETFs have expense ratios of 25 basis points or lower. In addition, there are California and New York funds in that group that offer double or triple tax exemption. Importantly, ETFs must report their securities owned daily allowing advisors to have complete transparency of holdings.

Source:  ETF.Com, 12/22/2017

Even in the closed-end space, expense ratios can be as low as 27 basis points. The advantages of adding some closed-end funds to the portfolio include:

• Active management in a less than efficient subsectors (see below).
• The ability to purchase funds at a discount to their net asset values (NAVs.) Although there are no guarantees that the fund will eventually trade at NAV there is the possibility of added returns if the discount narrows.

2. Explicitly diversify across the maturity spectrum. To control interest rate risk, portfolios should invest in funds of different durations. At the short end, defined maturity bond fund ladders can be created to ensure reinvestment at current rates when the fund matures so your clients have cash flow. available, if needed (see Lowering Bond Portfolio Volatility for more information of defined maturity bond funds.) There are also low-cost, targeted intermediate duration funds that have relatively narrow ranges of maturities.
3. Credit exposure needs to be managed carefully. Many “high yield” tax-exempt bond funds are significantly invested in lower than BBB rated bonds. It is important to have a balance of highly rated bond holdings with those that can dip into the junk bond area.
4. Include a mixture of active and passive funds. As in most other asset classes, low volatile sub sectors such as short maturity or investment grade funds can be represented by low-cost, passive ETFs.  But experts agree that exposures to longer maturities and “high yield” should be actively managed in order to control risks in these areas of the municipal market (see Muni Bonds: Changing Landscape Calls For Active Management).
5. Invest in funds providing monthly income, if necessary. Most of the ETFs and closed-end funds available provide income monthly. Many funds use a managed distribution policy that declares an even dividend per share monthly, throughout the year, even if the income to the fund is “lumpy.”  This could be attractive to clients who are depending on a regular amount of monthly income.

As an alternative to creating these effective municipal bond portfolios themselves, advisors can take advantage of separately managed accounts (SMAs) of these funds available from leading investment managers directly, or on brokerage and third-party platforms. Utilization of these SMAs can often take place at fees lower than mutual funds, increase transparency to advisors and clients, and allows the advisor to spend more time on client servicing and marketing.

iSectors® Tax-Wise Income Allocation Fundamentals

The iSectors Tax-Wise Income Allocation is a model portfolio strategically managed for tax sensitive investors seeking income for their portfolio.  This SMA Allocation invests in:

• Laddered defined maturity municipal bond ETFs.
• Passive ETFs targeted to specific municipal bond sectors.
• Low cost active funds whose goals are to invest in the most attractive tax-exempt securities in a diversified manner.

The portfolio’s average duration is expected to be between 4.0 and 6.0.  This high-quality strategy has an average credit rating of AA, 40% of the portfolio is rated AAA and 98% of the securities are investment grade.

Advisors that wish to expose client portfolios to diversified, low-cost, transparent and liquid tax-exempt holdings with attractive yields should consider the iSectors Tax-Wise Income Allocation!

If you are a financial advisor that wishes to learn more about effective methods for tax-exempt investing, please contact Scott Jones at 800-869-5184 or [email protected].  Alternatively, you may wish to register on our website www.isectors.com to review information on the Tax-Wise Income Allocation.

Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help you determine the best iSectors asset allocation for their portfolios.