Seeking stability amid uncertainty: the appeal of tax-aware ETFs

In the trade shock felt around the world, President Trump’s Liberation Day-inspired tariffs rocked the financial markets, seemingly affecting every sector – even the characteristically less risky ones.

Investors held their collective breath as the 10-year Treasury’s yield, which fell 14 basis points  in one day, spiked 42 basis points over the next five days in mid-April, challenging its reputation as a safe haven asset. For the year up to May 31, the 20-year US Treasury Index has swung between negative to positive performance five times.  Over the following weeks, the markets quickly retraced their steps, leaving investors to question, “Did that really happen?” 

Similar to prior market shocks like the Great Financial Crisis and COVID, ETFs served as a valuable tool for investors to express their real-time views across markets. Since they trade on public exchanges, ETFs offer intraday liquidity and allow investors to respond promptly to market shifts. They also typically have lower expense ratios than mutual funds and can help enhance portfolio diversification.

ETFs’ most defining feature may be their reputation for tax efficiency, especially compared to mutual funds. ETFs tend to disperse fewer capital gains due to generally lower turnover and their structure, which insulates ETF shareholders from the actions of other investors.

As investors sought stability and income amid the market uncertainty, they increasingly turned to fixed income ETFs, which have garnered $156 billion in inflows year to date as of May 31, according to Morningstar data. Investors’ continued search for innovative ways to seek to maximize income, particularly on an after-tax basis, has driven the appeal of tax-aware strategies within the fixed income ETF universe.

For decades, municipal bonds had been the primary approach for investors looking for tax-exempt income. What’s been overlooked is that depending on relative value, sometimes paying taxes on income derived from corporate or securitized bonds may result in higher after-tax returns than those from municipal bonds alone.

That’s where tax-aware ETFs come in. Unlike traditional municipal bond funds, which focus exclusively on tax-exempt income, tax-aware ETFs aim to expose investors to a broader opportunity set across of municipal and taxable bonds, like corporates and securitized. For example, TAXX, the BondBloxx IR+M Tax-Aware Short Duration ETF, is an active ETF that employs rigorous bottom-up security selection in an attempt to determine the ideal blend of tax-exempt and taxable bonds based on market conditions. 

While the municipal market was not immune to April’s intra-month volatility, tax-aware ETF investors may have benefitted from the rise – and subsequent fall – of the sector’s yield. During a month that posted positive returns just four times in the last ten years, the municipal market was pressured by record-setting supply, tax-day payments, and tariff-fueled uncertainty.

Against this backdrop, municipal bonds underperformed Treasuries, resulting in the highest muni/Treasury ratio since 2022 and a much welcomed, more attractive entry point for investors. The muni/Treasury ratio compares the yields of municipal bonds to U.S. Treasuries, typically before considering taxes. By comparing the ratio to its historical average, investors can determine whether municipal bonds are attractive relative to Treasuries. 

Tax-aware ETFs aim to deftly navigate, and capitalize on, this ever-changing tax-exempt vs. taxable relationship. In an environment characterized by uncertainty, ETFs – especially the tax-aware variety – are a compelling tool for those seeking after-tax income and stability.
 

Erinn King is chief strategy officer and co-head of client team at Income Research + Management, a privately owned, independent, fixed income investment management firm that serves institutional and private clients.