Money For the Rest of Us

Episode 540: Beyond Munis — New ETFs for Tax-Efficient Bond Investing

Host: J. David Stein
Date: October 8, 2025

Overview

In this episode, J. David Stein explores the evolving landscape of tax-efficient bond investing for individuals with taxable accounts. While municipal (“muni”) bonds have long been the standard for tax efficiency, new ETF innovations—particularly those employing options and unique strategies—offer additional tools for investors seeking to reduce taxes on bond income. Stein provides an in-depth analysis of how these products work, their relative merits, risks, and suitability for investors in different tax brackets.

Key Discussion Points & Insights

1. The Case for Municipal Bonds (Munis)

• Default Rates & Safety:
  • Investment-grade munis are historically safe, with a five-year cumulative default rate of 0.18%.
  • Two primary types:
    • General Obligation Bonds: Backed by taxing power.
    • Revenue Bonds: Supported by fees (utilities, toll roads, etc.).
  • “One reason that municipal bond default rates are so low is that these municipalities, these government entities, they have the power to tax and to raise fees and so that gives them the ability to service the debt.” (02:00)
• Tax Equivalent Yields:
  • Tax-exempt at the federal level; may also be state tax-exempt if in-state.
  • Example: Vanguard Tax-Exempt Bond ETF (VTEB)
    • 3.5% SEC yield; in a 35% tax bracket, tax-equivalent yield is 5.4%; in 22%, it’s 4.5%.
    • Higher yields (after tax) than Treasury ETFs of similar duration.
  • Duration risk—VTEB has a duration of 7.3 years: “If interest rates go up 1%, this ETF's price could fall by 7.3%.” (04:28)
• Short-term Munis:
  • JP Morgan Ultra Short Municipal Income ETF (JMST):
    • 0.7-year duration, 2.6% yield.
    • Lower yields may be less attractive after taxes, especially for those in lower brackets.
  • “...sometimes yields on muni bonds are so low that it doesn't make sense to invest in them even if you're at that higher tax bracket.” (06:01)

2. Buying Individual Municipal Bonds

• Some investors purchase individual munis to lock in yields and eliminate interest rate risk, holding to maturity for a guaranteed outcome.
• Lower work and complexity compared to building individual corporate bond portfolios due to munis' low default rates (especially in-state bonds).

3. Innovative Tax-Efficient Bond ETFs

A. Alpha Architect 1-3 Month Box ETF (BOXX)

• Strategy & Tax Efficiency:
  • Not a muni; uses a “box” options strategy to emulate short-term Treasury returns.
  • Generates returns as unrealized capital gains (not interest), taxed at (often lower) capital gains rates upon sale.
  • “...you're not getting it in the form of interest income. It's coming up as a unrealized capital gain.” (11:42)
• Mechanics:
  • Uses a mix of options (calls and puts) to construct a cash-equivalent payoff, capturing the risk-free Treasury yield through options market pricing.
  • Utilizes ETF creation/redemption to pass on embedded gains without triggering immediate taxes.
• Performance:
  • Very close to traditional short T-bill ETFs:
    • 2023: 5.04% for BOXX vs 4.94% for SPDR 1-3 Month T-Bill ETF.
    • “The strategy works...a way to earn short term treasury bond yields without having to pay ordinary income tax rate as long as the IRS doesn't clamp down on it.” (13:46)
• Risks:
  • Regulatory/IRS risk: possible that future rules could treat this as ordinary income.
  • Occasional taxable distributions if options mismanagement occurs (as in 2024).
  • Counterparty risk minimal as options are cleared through the OCC.

B. FM Compounder US Aggregate Bond ETF (CPAG)

• Strategy:
  • Owns a bond ETF tracking the Bloomberg Aggregate Bond index.
  • Right before the ETF’s dividend is paid, CPAG sells it and buys a substantially similar ETF to avoid receiving taxable distributions, then reverses after dividend ex-date.
  • Wash sale rules do not apply to regulated investment companies.
• Goal:
  • Accumulate returns as NAV appreciation (unrealized gains), deferring taxes until sale (potential for lower long-term capital gains taxes).
  • “...all the returns ends up just coming in the form of the price appreciation, an unrealized gain. And then the, the ETF holder can choose when to sell to recognize the gain.” (17:32)
• Caveats:
  • New product, limited track record.
  • Regulatory risk: Could be challenged under “conversion transaction” or “economic substance” doctrines.
• Variants:
  • Also a high yield version (CPHY) for non-investment grade bonds.

C. Yield Enhancer ETFs (NEOS BNDI, CSHI)

• Strategies:
  • Own underlying bond ETFs for core holdings.
  • Enhance income by selling put spreads on the S&P 500, collecting options premiums.
• Tax Aspects:
  • Not strictly tax-efficient for bond income; option income is 60% long-term, 40% short-term capital gains.
• Risks:
  • Exposed to equity market events despite being branded as bond ETFs.
  • Outperformed broad indices so far, but “looks good until there's a potentially an extreme event.” (22:19)
• Stein’s View:
  • “Nothing against those two ETFs but they're not a version where we're seeking greater tax efficiency as sort of supplements or replacements or complements to municipal bonds.” (23:33)
  • Cautions against relying solely on these for tax efficiency; situational use as yield boosters accepted.

4. Considerations for Investors

• Tax Bracket Relevance:
  • Munis and these alternative structures deliver the greatest benefit for those in high tax brackets; in lower brackets, taxable bonds or T-bills may be as good or better after tax.
• Regulatory Risk:
  • These innovative ETFs walk a fine line; future IRS rulings could retroactively classify income as ordinary, undermining the tax strategy.
• Yield vs Interest Rate Risk:
  • Stein’s model portfolios prioritize yield and limit unnecessary interest rate risk.
  • “If we're not getting paid to take interest rate risk...set up a portfolio that's not dependent on predicting the direction of interest rates.” (25:03)

Notable Quotes & Moments

• “Sometimes yields on muni bonds are so low that it doesn't make sense to invest in them even if you're at that higher tax bracket.” (06:01, Stein)
• “...you're not getting it in the form of interest income. It's coming up as a unrealized capital gain.” (11:42, Stein, explaining BOXX ETF)
• “The key is to understand them and understand what the risks are—the investing risk, the interest rate risk, the regulatory risk—and then make prudent decisions based on that.” (27:35, Stein)
• “Nothing against those two ETFs but they're not a version where we're seeking greater tax efficiency as sort of supplements or replacements or complements to municipal bonds.” (23:33, on NEOS funds)

Timestamps for Major Segments

• 00:00–06:45: The muni bond case, tax equivalent yield math, duration risk, and short-term muni analysis.
• 08:07–15:56: Introduction and deep dive into BOXX (Alpha Architect), strategy, tax mechanics, and risks.
• 16:40–21:30: CPAG and the “dividend dodge” strategy, regulatory context, extensions (high yield).
• 21:30–24:11: NEOS option-based bond ETFs (BNDI, CSHI): structure, tax treatment, and key risks.
• 24:11–27:35: Stein’s investment approach, model portfolios, and big-picture summary.

Conclusion & Takeaways

• New ETF structures are expanding options for tax-aware bond investors, but all come with risks—especially around IRS regulatory interpretation.
• Munis remain reliable for high-bracket investors, but alternatives like BOXX and CPAG may enhance flexibility, especially for those seeking to defer or reduce ordinary income tax exposure.
• Understand each product’s mechanics, risks, and tax implications before inclusion in a fixed-income portfolio.
• These tools should be considered complements, not replacements, for traditional bond and muni ETF strategies.

[End of Summary]