One of the best ways to purchase a portfolio of Muni bonds for individual investors, is to purchase a municipal bond mutual fund. These are funds that invest in a wide range of municipal bonds. Mutual funds come in all sizes and specialize in different durations and locations. There are short-term funds, intermediate and long-term funds. The key is to read the prospectus and key in on the securities that are owned by the fund.
Just like stock funds, bond mutual funds have expenses that investors need to pay. Some have upfront or even back end sales loads. This is a percentage that an investor pays to the fund, just for the right to invest with the fund. These are funds to avoid. We would also avoid mutual funds that use leverage or borrowed money. There is just too much downside risk and volatility with the use of leverage. A risk in mutual funds is the possible change in price of the fund, when everyone is heading toward the doors at one time. The fund needs to sell bonds to meet redemption requests.
A common method of using leverage in municipal bond mutual funds involves purchasing inverse floating rate bonds or Tender Option Bond Trusts (TOBs). Avoid funds that use these.
Mutual funds allow individuals who do not have large pocketbooks to be active in the municipal bond market. Individual bonds are best for people prepared to invest more than $250,000 in bonds (this allows the investor the flexibility to generate a laddered portfolio that covers the range of bonds required to have a balanced portfolio. The tax benefit for high-income households makes Muni’s attractive.
Try to find funds that do not own auction rate securities, inverse floaters, and other volatile investments. Mutual funds with larger asset bases, say over $1 billion, are more durable and times when the shareholder redemptions occur. They won’t have to sell as often, as smaller funds may have to do.
Some mutual funds also avoid the smaller and unrated municipal bonds, ones that are more prone to problems. If a mutual fund has the majority of their portfolio in unrated bonds, which have not been tested by rating’s firms, we would probably not want to own the fund. Unrated Muni bonds are usually not backed by normal Municipalities. You are relying on the fund manager’s expertise when he purchases these non-rated bonds.
The average duration of a mutual fund is an important attribute to look at, when purchasing a bond mutual fund. It is a measure of a bond fund’s sensitivity to changes in interest rates. The greater the average duration of a fund’s holdings, the more its share price will fluctuate when interest rates change. If a bond mutual fund’s average duration is 2.5 years, a 1 percentage point rise in interest rates would lead to an estimated 2.5% decline in the share price or net asset value. A 1 percentage point decline in rates would likely lead to a 2.5% rise in the share price. Increase your duration if you think interest rates will fall or deflation will occur. Reduce your duration if you believe interest rates are rising and inflation is occurring. In a rising interest rate environment, investors may want to hold bond mutual funds with shorter durations of around 2-4 years.
Keep in mind that municipal bond mutual funds usually have a high degree of correlation in pricing with U.S. Treasury bonds. They will increase or decrease in value as the bond market fluctuates (interest rate risk), even though they possess unique credit risks associated with projects, municipalities, and states.
Active municipal bond mutual fund managers continuously monitor credit risk in their portfolio and adjust to changes in interest rates. They also should look for attractively priced bonds. While the best active managers can only slightly increase performance, they should be able to minimize downside risk significantly.
Purchase municipal bond funds that hold high-quality bonds, preferably those with credit quality rated AA or better. Avoid high-yield municipal bond funds which own lower quality bonds and unrated bonds, which are more prone to default.
Owning national municipal bond mutual funds can add diversification because the bonds are purchased from any state whereas a single state municipal bond mutual fund is forced to buy bonds of just a single state. With a single state fund, there may be limited supply of municipal bonds and hence, higher prices on those bonds. There is also the possibility of higher yields. Even after paying state income tax, shareholders of a national municipal bond mutual fund may receive a better deal.
Defined maturity mutual funds
In June 2011, Fidelity launched several defined maturity municipal bond mutual funds. The funds will be liquidated on June 30 of each specific year and any remaining value will be returned to shareholders of record. These funds attempt to achieve what individual investors typically do with bond ladders, while including the versatility of a mutual fund. Holding one of these funds until maturity won’t exactly guarantee you get back the same net asset value that you paid in that. Not all bonds will mature exactly on the June 30 liquidation date, resulting in slightly lower yields as they close in on maturity. These funds charge an expense ratio of 0.40%, which is pretty reasonable.
These Fidelity municipal bond mutual funds will target 2015, 2017, 2019, and 2021 as maturity dates: Fidelity Municipal Income 2015 (FMLCX), Fidelity Municipal Income 2017 (FMIFX), Fidelity Municipal Income 2019 (FMCFX), and Fidelity Municipal Income 2021 (FOCFX).
These are brand-new funds, so I would give them time to iron out the kinks and establish a track record especially during any downdrafts.
Mutual funds screener
There are a number of great funds, each broken down into a different category covering the municipal bond markets. Using a mutual fund screener is an efficient and intelligent way to find the best combination of criteria to match your goals. Morningstar has a very good screener, which handles most criteria. This type of tool will allow you to ladder or diversify your portfolio through mutual funds in an efficient manner.
Morningstar’s favorite National intermediate term municipal bond fund picks and California intermediate term municipal bond fund picks.
Recently municipal bond ETF’s have been issued. These are exchange traded funds that trade like stocks, but have a portfolio of municipal bonds as their holdings. These new ETF’s are thinly traded, and do not have a track record so we would proceed with caution.
There are Closed End bond funds that concentrate on the municipal bond market. A Closed End fund is an investor pool, where there are a limited number of shares issued. New shares are rarely issued after the fund is launched; shares are not normally redeemable for cash or securities until the fund liquidates. The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the net asset value (NAV) per share. The NAV may differ significantly from the current price. Many Closed End funds, which trade like stocks, utilize leverage, which creates volatility. Additionally, many close end fund have high fees.
Managed Muni Accounts
Another way for an investor to gain access to the municipal bond market without actively managing a portfolio is to hire an account manager. Firms such as JP Morgan, Goldman Sachs and Citi cater to high net worth clients, who usually open accounts of more than 1 million dollars. There are muni bond managed accounts for those with a least $250,000 to invest in bonds, at brokerages such as Schwab using managers such as Pimco (0.35% expense ratio) and Nuveen (0.65% expense ratio) . Some of these managers use techniques as described in How to Perform Active Municipal Bond Management
Mutual Funds to Consider
There are many great mutual funds; some of the top firms include Fidelity, Legg Mason, Vanguard and T. Rowe Price. Look for no-load, low expense, high credit quality mutual funds with a manager that has a solid track record. Short and intermediate-term funds are the best bets.
Additional Related Municipal Bond Educational Articles:
What are municipal bonds?
How to Research Municipal Bonds
The Risks of Owning Municipal Bonds
How to Buy And Sell Municipal Bonds
Municipal Bond Mutual funds – Municipal Bond Managed Accounts
What Are Closed-end Municipal Bond Funds?
What are Municipal Bond Exchange Traded Funds or ETFs
How to Make a Municipal Bond Ladder
How to Select Municipal Bonds
Municipal Bond Trading Example
How to Perform Active Municipal Bond Management
Municipal Bond Books and Educational Resources