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Home > Capital Markets Corner: Let’s Talk Munis

Capital Markets Corner: Let’s Talk Munis

Many investors seeking income generation may not immediately think of exchange-traded funds (ETFs). But perhaps they should, says David Mann, our head of Capital Markets, Global ETFs. He explores why municipal bond ETFs are worth a look—particularly amid an aging equity bull market.

David Mann
Head of Capital Markets, Global Exchange-Traded Funds (ETFs)
Franklin Templeton Investments

Even though the majority of assets this year have gone into broad based US and international equity ETFs, overall we continue to see the universe of ETFs grow across a myriad of asset classes, sectors and countries. One of these asset classes that may not be the most common one associated with ETFs is municipal (muni) bonds. There are several reasons to consider a muni-minded ETF, but first let’s start at the beginning and look at the types of municipal bonds in the market, and why they are issued.

Types of Municipal Bonds

Muni bonds, issued by local authorities, fall into two categories. Revenue bonds pay for various projects that generate revenue, as the name implies. These may include entertainment venues such as a sports stadium, or infrastructure projects such as a toll road that collects fees for use.

General obligation bonds, meanwhile, don’t generate revenue. The taxing power and authority of the issuer backs these bonds—that is, state and local governments. Projects financed by general obligation bonds may include things that a wide population will enjoy without paying a specific fee to do so, such as a municipal park or bicycle path.

As you drive around your home state or town, you’ll likely see many examples of things you encounter and enjoy every day that municipal bonds have made possible. So when you invest in muni bonds, you really can see concrete evidence of your investment in action!

The Role of Munis in a Portfolio

Munis play such an important role in funding projects that benefit society, but they can also play an important role in an investor’s portfolio. And given current tax rates, the potential tax-free benefits of municipal bond funds makes them even more attractive for many investors. 1

There are three main reasons to consider munis in a portfolio.

A source of yield. Municipal bonds have often offered a higher tax-equivalent yield than other types of bonds. See chart below for a look at yields as of September 30, 2017, as an example.

1117_MuniYield_NoD

For illustrative purposes only; not representative of the performance of any Franklin tax-free income or municipal bond fund/ETF. Sources: 2017 Morningstar (BofA Merrill Lynch Current US Treasury (10-Y) Index, Barclays Municipal Bond (AAA) Index, Barclays US Aggregate Corporate (A) Index, Barclays Municipal Bond (A) Index, Barclays US Aggregate Index, BofA Merrill Lynch US Corporate Index, Barclays Municipal Bond Index. Indexes are unmanaged and one cannot invest directly in an index. They do not include fees, expenses or sales charges. See www.franklintempletondatasources.com for additional data provider information. The results depicted do not reflect the fees or charges an investor would incur with an investment in a municipal bond fund. If such costs were included, the performance shown would have been lower. Past performance is not an indicator or guarantee of future results. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; interest payments and principal are guaranteed. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable. The yield to worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The tax-equivalent return is used by investors to compare taxable and tax-exempt securities after accounting for federal taxes (excluding AMT). For this comparison, we used the maximum tax rate of 39.6%, plus the 3.8% tax from the Affordable Care Act. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable.

Diversification. The negative correlation that munis have generally had with US stocks may make them an attractive option for a well-diversified portfolio.2 See the graphic below for a look at the five-year period ended September 30, 2017. I think this is a particularly compelling case today, as the current US equity bull run has now passed eight years, the longest in history. While it certainly could continue on for longer, it makes sense to think about ways to diversify today.

1117_MuniNoD_correlation

Municipal bonds are represented by Barclays Municipal Bond (AAA) Index, US stocks are represented by S&P 500 Index, commodities are represented by Bloomberg Commodity Index, US corporate bonds are represented by BofA Merrill Lynch US Corporate Index, US Treasuries are represented by BofA Merrill Lynch Current US Treasury (10-Y) Index and US bonds are represented by Barclays US Aggregate Index. Indexes are unmanaged and one cannot invest directly in an index. They do not include fees, expenses or sales charges. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; interest payments and principal are guaranteed. See www.franklintempletondatasources.com for additional data provider information.

Low Default Rates

Aside from the a few high-profile cases making headlines, munis have historically had a very low default rate compared to other fixed income investments. Again, the graphic below offers a snapshot of defaults from 1970–2014. This is not to suggest corporate credit is to be avoided because the default rates have been higher, but rather, why one should think carefully, and employ a selective approach.

1117_Muni_NoD_default

For illustrative purposes only; not representative of the performance of any Franklin tax-free income or municipal bond fund/ETF. Source: Moody’s Corporation. Most recent annual data available. A speculative-grade bond has a rating of lower than Baa, an investment-grade bond has a rating of Baa or higher. Past performance is not an indicator or guarantee of future performance.

Munis in an ETF Wrapper

Bringing this back to ETFs, in a previous blog, I walked through some of the misconceptions around transparent active ETFs.  As a quick recap, all of the things people like about investing in ETFs (transparency, liquidity and efficiency) apply to active ETFs as well. That would include active muni ETFs.

We believe municipal bonds are a great underlying asset class for active ETFs. Within the muni space, indexes hold very few of the nearly 1 million available muni bonds in the marketplace.

For example, as of June of this year, the Bloomberg Barclays Municipal Bond Index held roughly 50,000 muni bonds.3  An ETF tracking that index would hold a subset of those 50,000 muni bonds as the portfolio manager optimizes the portfolio to match that index.

Within the municipal bond space, making an active decision to select a subset of bonds in order to best track an index (that itself is a subset of the investable universe of bonds) seems counter-intuitive.

An actively managed ETF is not constrained to a particular index. News and events can happen quickly, and while an index can’t quickly jettison a muni bond from the index, an active manager can do so from his or her fund.  So, we think muni bonds are a great asset class for active management which is readily available in the ETF wrapper that many investors have come to love.

So, as you head off to cheer on your favorite sports team at its home stadium or enjoy some outdoor recreation with your friends and family, consider that municipal bonds may have made it possible. And, hopefully you have a better sense of how muni-bond ETFs could help finance your own investment goals, too.

David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

To comment or post your question on this subject, follow us on Twitter @LibertyShares and on LinkedIn.

The Franklin Liberty Municipal Bond ETF seeks to provide investors with a high level of current income that is exempt from federal income taxes by investing at least 80% of its net assets in municipal securities whose interest is free from federal income taxes, including the federal alternative minimum tax.

Franklin Liberty Intermediate Municipal Opportunities ETF seeks to provide investors with a high level of current income that is exempt from federal income taxes by investing at least 80% of its net assets in municipal securities whose interest is free from federal income taxes, including the federal alternative minimum tax.

What are the Risks?

All investments involve risks, including possible loss of principal. Because municipal bonds are sensitive to interest rate movements, the funds’ yield and share price will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a fund adjust to a rise in interest rates, the fund share price may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. The funds may invest a significant part of their assets in municipal securities that finance similar types of projects, such as utilities, hospitals, higher education and transportation. A change that affects one project would likely affect all similar projects, thereby increasing market risk.

For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable.

Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. The prospectus contains this and other information.

Please read the Franklin Liberty Municipal Bond ETF prospectus and/or the Franklin Liberty Intermediate Municipal Opportunities ETF prospectus carefully before investing or sending money.

ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns.

ETF shares may be bought or sold throughout the day at their market price, not their Net Asset Value (NAV), on the exchange on which they are listed. Shares of ETFs are tradable on secondary markets and may trade either at a premium or a discount to their NAV on the secondary market.

For more information on any of our funds, contact your financial advisor or download a free prospectus.

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1. Dividends are generally subject to state and local taxes, if any. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable.

2. Diversification does not guarantee profit nor protect against risk of loss. Correlation is the statistical measure of the degree to which the movements of two variables are related. 1 = perfect positive correlation and -1 = perfect negative correlation.

3. Source: Bloomberg, as of June, 2017.