High-Yield Munis vs. Taxable Bonds: 4 ETFs for Different Income Needs

Income-oriented investors, including lots of retirees, often switch their portfolios from a growth focus to an income-based one once they are officially in retirement. Many of them opt for dividend stocks, bonds, or other REITs for monthly income. For those who do not have the time or resources to monitor a portfolio of separate securities and their respective income disbursements, maturities, and market fluctuations, mutual funds and ETFs can be the answer.

However, there are differences to consider when selecting income-based ETFs or mutual funds. While many of them are equivalent to choosing specific bonds, there are other aspects to deliberate about, depending upon individual circumstances.

Key Points

• Corporate bond ETFs generally have notionally higher yields than Municipal Bond ETFs.

• Interest from Muni ETFs are not subject to federal income tax, which can equate to, and possibly surpass corporate ETF net income yields, depending on one’s tax bracket.

• Due to their index benchmark compositions, Muni ETFs will average less volatility than corporate bond ETFs.

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Exchange Traded Funds (ETF) and Mutual Funds

By and large, ETFs offer a number of advantages over mutual funds, including lower expense ratios, intraday pricing, and objective index based management, vs. subjective management decision making.

Exchange Traded Funds and Mutual Funds share a number of similarities:

• Both are funds comprising a mixed portfolio of securities, diversified to mitigate single security risk.

• Both ETFs and mutual funds offer retail investors a prorated stake in the funds proportional with their respective investments.

• Mutual Funds and ETFs both carry expense ratios as management fees.

Differences between ETFs and Mutual Funds include:

• ETFs are traded on either the NYSE or NASDAQ like a stock. Mutual Funds can be obtained on an exchange or by direct subscription.

• A mutual fund is bought and sold based on its Net Asset Value (NAV) quote for the day. ETFs trade like stocks, and can fluctuate in price over the course of the day.

• ETFs have a fixed number of shares, like a stock. Mutual Funds have a cumulative cash value based on their NAV, and can add or delete shares as needed, based on buy or redemption orders.

• Unlike mutual funds, which are actively managed, the bulk of ETFs are passively managed, and are objectively benchmarked against a designated index.

For income investors, a basket of securities in an ETF configuration can be a much easier investment to make than researching and selecting individual bonds. Bonds normally offer yield, inversely proportional to their rating, so the higher the safety rating, the lower the yield, and vice-versa.

Municipal vs. Corporate Bonds and Their ETFs

Depending on one’s tax bracket, municipal bonds, with their generally safer credit ratings and tax exemption aspects, might be a viable alternative to corporate bonds for income.

In terms of yield, most investors will opt for corporate or municipal bonds, which have a much broader selection of variation to choose from, compared to higher rated and lower yielding US Treasuries. Credit risk ratings from Moodys, S&P or Fitch, along with coupon interest and maturity are the main factors for determining price. The same holds true for ETFs.

Corporate Bonds are debt instruments issued by companies for use in financing various operations or projects. Corporate debt of public companies is often used to finance company obligations, while stock is used for acquisitions. Depending on their creditworthiness, corporations may have a series of bond issues with varying maturities and interest coupons. Preferred stock, which has a par value and an annual interest payment just like a bond, is usually categorized as equity for accounting purposes, although analysts will include preferred stock coupon obligations in calculating a company’s debt obligation overhang.

Corporate bond ETFs track a variety of different indexes. For high-yield bonds, which often are below investment grade and ranked in “junk bond” territory, some of those indexes include:

• ICE BofA BB U.S. High Yield Constrained Index

• Solactive USD High Yield Corporates Total Market Index

• Bloomberg U.S.Corporate High Yield Total Return Index

Municipal Bonds are debt instruments issued by states or cities for use in financing various operations or projects.

In general, corporate bond yields run higher than municipal bonds. However, since municipal bonds are issued by local government entities, their coupon yields are exempt from federal income taxes, as well as state taxes, if the bondholder is a resident of that state. The only municipal securities that are fully exempt from local taxes in all 50 states are issued by Puerto Rico, Guam, US Virgin Islands, American Samoa, and Northern Mariana.

Municipal bond ETFs have a risk mitigation advantage over individual municipal bonds. Since the ETFs are pools of various municipal bonds, the overall portfolios are less subject to the risk of default. While the majority of states are usually rated AAA or AA, certain catastrophic situations, such as the Los Angeles wildfires in CA or Hurricane Helene in NC, could make those state’s or city’s bonds potentially face a temporary budgetary shortfall. This may trigger an interim default on a coupon payment.

Additionally, individual municipal bond issues are more frequently subject to calls than corporate bonds. If a bond is called at an earlier date than its stated maturity, it is akin to paying a mortgage off early. However, that means the bond is redeemed and the principal must then seek another bond to generate equivalent coupon interest. Municipal bond ETFs already have other bonds earmarked to seamless swap in the event of any calls for bonds in the portfolio.

On the other hand, because of their mixed security portfolios, municipal bond ETFs are exempt from federal income tax, but nor local taxes. State specific municipal bond mutual funds are exempt from both federal and local taxes for residents of those states.  High-Yield municipal bond ETF indexes include:

• ICE High Yield Crossover Municipal Bond Index

• Bloomberg Municipal Yield Index

• S-Network Municipal Bond Closed-End Fund IndexSM

The A/B Comparison

Head to head, both high-yield corporate ETFs and high-yield corporate ETFs have advantages over their individual bond counterparts for retail investors.

There are a number of both high-yield muni ETFs and high-yield corporate bond ETFs available, from the major issuers, such as Vanguard, BlackRock, State Street, et. al. While one should research for their own preferences, an overview of some of the top rated examples of each asset class might include for high yield corporates:

• iShares Broad USD High Yield Corporate Bond ETF (CBOE: USHY)

• SPDR Portfolio HighYield Bond ETF (NYSE: SPHY)

And for high-yield munis:

• SPDR Nuveen Bloomberg High Yield Municipal Bond ETF (NYSE: HYMB)

• BlackRock iShares High Yield Muni Income Active Fund ETF (CBOE: HYMU)

To calculate the municipal bond taxable equivalent yield, for example, of HYMB for someone in the 35% bracket, the formula is: muni yield/(1.0 – tax bracket) = taxable equivalent yield.

4.23% / (1 – 0.35) = 4.23% / 0.65 = 6.507%.

The convenience and ease of utilizing bond ETFs in place of individual bonds also offer additional risk mitigations. Unless a retail investor has the bandwidth to monitor individual bonds, the ETF option is definitely worth consideration.