Investment Primer: The Municipal – Fixed Income Composite

What, Why, and How of Municipal Fixed Income

The Municipal – Fixed Income composite includes funds that invest in debt issued by states, cities, counties, and other government entities to fund public projects like schools, highways, and water systems. The “why” is the primary distinguishing feature of this asset class: the income generated is typically exempt from federal income taxes. For investors in high tax brackets, this tax advantage can result in a higher after-tax return than a taxable bond with a similar or even higher yield.

The “how” is achieved by holding portfolios of these municipal bonds (“munis”). Funds in this composite can be passive Beta strategies that track a broad municipal bond index or actively managed Factor or Tactical funds where a manager makes decisions on credit quality, duration, and bond selection. The primary goals are tax-efficient income and capital preservation.

Deconstructing the Municipal Bond Market

To effectively use municipal bond funds, it’s essential to understand their unique tax treatment, the different types of bonds, and the two primary risks that drive their performance: credit risk and interest rate risk (duration).

The Nuances of Tax Treatment

The main attraction of municipal bonds is their tax-advantaged income.

• Federal Tax Exemption: For all municipal bond funds, the income distributed is generally exempt from federal income taxes.
• Single State Funds & The “Double” or “Triple” Tax Exemption: A key feature of the muni market is the availability of single-state funds. For an investor who resides in that specific state (e.g., a California resident buying a California municipal bond fund), the income is often exempt from state and local income taxes as well. This is known as a “double” (federal and state) or “triple” (federal, state, and city) tax exemption, which can significantly enhance the after-tax yield.

Debt Types

Municipal bonds are generally categorized by the source of their repayment funds.

• General Obligation (GO) Bonds: These are backed by the “full faith and credit” of the issuing government entity, meaning they are supported by the issuer’s general taxing power. They are typically considered to be very high credit quality.
• Revenue Bonds: These are backed by the revenue from a specific project or source, such as tolls from a bridge, ticket sales from an airport, or water and sewer fees. Their credit quality depends on the financial health of that specific project.

The Two Key Risks

• Credit Risk: This is the risk that the issuing municipality will default on its payments. While municipal defaults are historically rare, they can happen. Credit rating agencies assign ratings to indicate creditworthiness.
  • Investment Grade: Most municipal bonds are investment grade (BBB- or higher), indicating a low risk of default.
  • High Yield (“Junk”): A smaller segment of the market consists of lower-rated bonds that offer higher, tax-free yields to compensate for greater credit risk.
• Interest Rate Risk (Duration): This is the risk that a bond’s price will fall when interest rates rise. Duration measures a bond’s price sensitivity to a 1% change in interest rates. A bond with a duration of 7 years would be expected to lose approximately 7% of its value if interest rates rise by 1%.

A Practical Guide to Locating Funds in the ETF Action Database

The municipal bond universe is large and segmented. ETF Action’s classification system is designed to help users precisely navigate this space.

Foundational Screening: Building the Initial Universe

• Step 1: Select the Database. Navigate to the ETF, Mutual Fund, or other desired database.
• Step 2: Filter by Asset Class. Select Asset Class = Fixed Income.
• Step 3: Filter by Composite. Select Composite = FI: Municipal.
• Step 4: Filter by Category. This is the primary filter for strategy and geography. Here you can find broad national funds (Fixed Income: Municipal – Intermediate), high-yield funds (Fixed Income: Municipal – High Yield), or, critically, Single State funds (e.g., Fixed Income: Municipal – Single State CA, … – Single State NY).
• Step 5: Filter by Selection & Implementation. These are the key filters for risk. The Selection filter targets Credit Risk (e.g., Credit: Investment Grade, Credit: High Yield). The Implementation filter targets Duration (e.g., Duration: Short, Duration: Intermediate, Duration: Long).

Advanced Filtering: Refining Your Peer Group

• Brand (Issuer), AUM, Expense Ratio, Liquidity: Use these standard filters to narrow the list to viable candidates.
• Strategy & Discipline: Is the strategy Beta or Factor and is it Passively or Actively managed?

A Framework for Evaluating Municipal Funds

A thorough evaluation of a municipal fund requires looking beyond its stated yield to understand its underlying risk exposures and true after-tax benefit.

Risk/Return Analysis: The Importance of Benchmarks

The foundational step is to analyze a fund’s historical risk and return profile. ETF Action assigns a Beta Tracker to each category (e.g., MUB for national intermediate munis) to provide a relevant peer for comparison.

• Total Return: How has the fund performed over various time periods compared to its benchmark?
• Standard Deviation (Volatility): Was the fund more or less volatile than its benchmark?
• Sharpe Ratio: Did the fund provide better risk-adjusted returns?
• Tax-Equivalent Yield: This is the most important metric for comparing a municipal bond fund to a taxable bond fund. It calculates the yield a taxable bond would need to offer to equal the tax-free yield of the muni fund, based on an investor’s tax bracket.

Quantitative Analysis: The Power of Look-Through Analytics

A fund’s name tells you its category, but its holdings reveal its true risk profile. Look-through analysis is critical for municipal bond funds.

• Credit Quality Breakdown: While a fund’s credit classification (e.g., Investment Grade) directs you to its targeted rating bucket, the Option-Adjusted Spread (OAS) is the market’s way of assessing credit risk in real-time. OAS can vary widely even for funds within the same rating category, and it provides a truer picture of the risk investors are being compensated for.
• Duration & Yield Curve Positioning: What is the fund’s precise effective duration? How are its holdings positioned along the yield curve?
• Geographic & Issuer Concentration: For a national fund, is it heavily concentrated in bonds from one state (like California or New York)? For a single-state fund, is it overly exposed to a single issuer or project?

While a detailed, manual look-through analysis provides the deepest insights, it can be time-intensive. ETF Action’s derived analytics are designed to simplify this process by providing a completely objective, rules-based framework. The classifications, such as the Fixed Income – Credit Assignment (Investment Grade, High Yield) or Fixed Income – Duration Assignment (Short, Intermediate, Long), are rules-based labels that place a fund into a specific bucket. The derived analytics, like the Fixed Income – Credit Quality Tilt Rating or the Fixed Income – YTM Tilt Rating, offer a more nuanced view. They quantify the intensity of a fund’s characteristics on a numeric scale relative to a broad market benchmark. This dual system provides a powerful framework to more efficiently search for funds and conduct an initial evaluation.

Qualitative Analysis: Evaluating the Strategy

• For Passive Funds (Beta): The key is to understand the index methodology. How does the index select and weight bonds?
• For Active Funds (Factor, Tactical): The focus is on the manager’s process. How do they make decisions about duration, credit, and security selection? The qualitative review should confirm that the manager’s philosophy is reflected in the portfolio’s look-through characteristics.

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