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Adding Some Spice to a Boring, But Popular Bond Trade

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As of the end of October, the Federal Reserve hiked interest rates three times this year with many fixed income market participants still betting on a fourth rate increase coming in December. A predictable reaction of the Fed’s 2018 tightening efforts is investors departing long-dated bonds and the related exchange traded funds (ETFs) in favor of lower duration alternatives.

On a year-to-date basis, the two top bond ETFs in terms of assets added are a short duration Treasury fund and a floating rate fund. That theme is continuing the fourth quarter where the top asset-gathering fixed income ETFs are of the ultra-short variety.

In many cases, trimming duration also means reducing yield. For example, the ICE U.S. Treasury Short Bond Index and the Bloomberg Barclays 1-3 Month U.S. Treasury Bill Index have 30-day SEC yields of just 2.15 percent and 1.96 percent, respectively.

Fixed income investors looking to manage interest rate risk while still maintaining a decent income profile can consider short-dated and ultra-short municipal bonds. Until recently, there were no ETFs dedicated to ultra-short municipal bonds. The JPMorgan Ultra-Short Municipal ETF (JMST) changed that.

Actively managed, the JPMorgan Ultra-Short Municipal ETF (JMST) holds 214 municipal bonds, comprised primarily of investment-grade fixed, floating-rate and variable-rate securities.

Good Timing

Broadly speaking, municipal bond strategies have been better than longer duration bond funds this year. In this case, “better” means “less bad.” The S&P National AMT-Free Municipal Bond Index, which has an effective duration of 6.14 years, is lower by nearly 1.20 percent this year.

JMST’s managers aim for a duration of two years or less, which can help reduce volatility, indicating the fund is potentially well-suited for the current interest rate environment. Aside from managing interest rate risk, JMST offers other perks.

Municipal bonds are tax-exempt at the federal level and, in many cases, at the state and local levels, too, making the asset class appealing to investors in high income tax states such as California, New Jersey, New York and Oregon.

Keeping with the themes of tax policy and JMST’s good timing, the tax reform legislation passed late last year capped state and local tax deductions at $10,000, a move derided by some taxpayers in high income tax states. While controversial, that policy makes municipal bonds more appealing for investors facing large tax bills.

JMST’s active management and focus on higher quality munis could prove to be advantageous for investors if unexpected chaos arises from this year’s midterm elections.

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“Votes for governor in 36 states and the majority of state legislative seats will be determined next week,” said Fitch Ratings. “Although Fitch rates to fundamentals rather than the political cycle, a material change in fiscal policy and/or increased or reduced contention in financial decision-making can be relevant for credit performance, particularly if and when the broader economy slides into recession. Due to biennial cycles, most states will be debating budgets in 2019.”

At the Federal level, election results are unlikely to sting muni investors for an extended period.

“For individuals, even with a worst-case scenario of an assumed reduction of the top tax rate from 37 percent to 27 percent, we believe this would have a muted effect with AAA rated municipal tax equivalent yields holding their relative value over U.S. Treasuries with the same duration,” according to Clark Capital Management Group.

Favorable Fee

Another benefit of the JPMorgan Ultra-Short Municipal ETF (JMST) is a favorable fee. With a net expense ratio of 0.18 percent per year, or $18 on a $10,000 investment, JMST is one of the least expensive municipal bond ETFs, active or passive. JMST’s fee is also just a fraction of what is found on some of the largest actively managed aggregate bond ETFs.

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