Municipal bond unit investment trusts have become a popular way for retail investors to gain exposure to the municipal bond market in recent years. As their name implies, these products pool together a portfolio of municipal bonds and divide it into individual units that are sold to investors. While municipal bond unit trusts offer diversification and relative simplicity, they also come with some unique risks that investors should fully understand before buying in. In this article, we will provide an overview of how municipal bond unit trusts work, their potential benefits, and the key risks to be aware of when investing in them. With hundreds of billions of dollars now invested in muni unit trusts, gaining a proper understanding of their pros and cons is critical for any investor looking to tap into the tax-exempt income provided by the municipal bond market.
Municipal Bond Unit Trusts Offer a Portfolio Approach
The defining feature of a municipal bond unit trust is that it takes a portfolio approach, holding a basket of individual municipal bonds rather than just one. The portfolio is carefully constructed by the trust sponsor to meet stated investment objectives, which usually involve providing income that is free from federal and/or state taxes. Investors in the trust are able to gain exposure to many more municipal bonds than they could likely buy individually, providing diversification across issuers, geographies, maturities, and bond types. The bonds in the portfolio are fixed at the trust’s inception, meaning that the trust will usually follow a buy-and-hold strategy until the bonds mature over a defined period, often 10-30 years. This means the trust has low turnover and therefore relatively low management fees compared to actively managed municipal bond funds.
Unit Trusts Offer Simplicity for Investors
Another advantage of municipal bond unit trusts is their simplicity and transparency for investors. An investor knows upfront exactly which bonds they are buying into since the portfolio is fixed. The bonds are typically investment grade issues that generate tax-free income over a defined period. Investors don’t need to worry about the portfolio manager changing holdings or strategies. Pricing is straightforward as well – the value of a trust unit changes daily based mostly on the value of the underlying bonds. Investors can focus on the income generation capacity of the trust rather than trying to analyze and pick individual bonds. This simplicity allows retail investors with smaller account sizes to gain targeted exposure to the municipal bond asset class.
Liquidity and Costs Vary by Trust Type
There are some key variations, however, when it comes to liquidity and costs of municipal bond unit trusts. Traditional trusts have a defined termination date when the bonds mature, so they are less liquid for investors who want to cash out early. More modern trusts issue units in perpetuity, meaning the portfolio is refreshed with new bonds as old ones mature. These perpetual trusts provide ongoing liquidity for investors. In terms of costs, brokers typically charge a front-end load fee for unit trusts that is higher than what mutual funds charge. However, ongoing trust expenses tend to be lower over the long run. Investors should pay close attention to the total cost structure before investing.
Interest Rate Risk is a Key Consideration
While municipal bond unit trusts provide diversification, investors still bear considerable interest rate risk. Trusts invest in long term bonds to maximize tax-free income, but if interest rates rise, those bonds can decline in value since newly issued bonds will offer higher yields. Many unit trusts have seen double digit losses in 2022 as the Federal Reserve has hiked rates. The longer the maturity of the bonds in the trust, the higher the interest rate risk. Investors should target maturity dates that align with their investment horizon to minimize this risk. Overall duration risk management is another key responsibility of the trust sponsor.
Default Risk Remains for Individual Bonds
Another risk that investors retain in a municipal bond unit trust is default risk at the individual bond level. While defaults within a diversified trust are rare, they can and do happen occasionally. If an issuer within the trust defaults, investors who hold units of the trust will realize losses. The impact on the overall trust is diminished through diversification, but investors have no recourse against defaulting issuers as would be the case with owning individual bonds. Assessing the financial strength of issuers in the trust portfolio is an important part of evaluating a potential investment.
In summary, municipal bond unit investment trusts can be an attractive option for investors seeking tax-advantaged income and portfolio diversification. However, the unique risks around interest rates, costs, and bond defaults need to be properly evaluated. Building a solid understanding of how municipal bond unit trusts work will allow investors to make informed investment decisions.