As the old adage goes, “Nothing is certain except death and taxes.” And with tax season upon us, it’s time to face the fact that many investors should be expecting larger and nastier taxes.
From lower phase-out rates for deductions to new tax charges related to Obamacare, most of us will be sending a bigger check to the IRS every year. And it seems like that fact is only going to get worse — regardless of who’s in office.
But there are ways to investors to reduce the bite of taxes, especially those looking for income from their portfolios today.
The best, perhaps, is still in municipal bonds.
Municipal bonds — or munis as they are commonly called — are issued by local and state government and agencies in order to help fund their daily activities or a special project. They’re awesome investments for higher earners because they offer investors tax-free income at the federal and sometimes state level. In fact, in some cases a boring muni bond can be worth more than other exotic and higher-yield bonds when taxes are taken into effect.
And exchange-traded funds (ETFs) remain the best way to get munis into your portfolio. Here are four municipal bond ETFs to buy today to start working reducing your 2015 taxes.
Municipal Bonds — iShares National AMT-Free Muni Bond ETF (MUB)
When it comes to muni bond ETFS, the iShares National AMT-Free Muni Bond ETF (MUB) reigns supreme. The ETF is the largest in the space, with robust trading volumes and more than $4.2 billion in assets under management.
MUB deserves to be investors’ first stop when looking at municipal bonds.
MUB tracks the vast universe of investment-grade munis that aren’t subject to the alternative minimum tax (AMT). That means MUB mostly focuses on general revenue, sewer, and other “boring” municipal bonds. There’s no exotic fair like new stadium or monorail bonds in the fund.
Currently, the ETF owns more than 2,400 different municipal bonds, with California, New York and Texas being the largest issuers of its holdings. Credit quality remains good, as does the duration at 6.33 years. MUB is firmly in the sweet spot with regards to duration and interest rate risk.
As far as the income factor goes, MUB has trailing 12-month yield of 2.71%. While that may seem low, the tax equivalent yield is actually 4.04%. That’s not too shabby and certainly beats the pants off of any savings account product or even treasuries.
Expenses for MUB run a cheap 0.25%, or $25 per $10,000 invested.
Municipal Bonds — SPDR Nuveen Barclays ST Muni Bond ETF (SHM)
While MUB maybe in the intermediate sweet spot, there is still some risk that when the Fed raises rates, MUB could see some capital losses. Bond prices have an inverse relationship with regards to interest rates. For investors concerned about duration, the SPDR Nuveen Barclays ST Muni Bond ETF (SHM) makes a great play.
SHM focuses on the shorter end of the municipal bond spectrum by tracking the Barclays Managed Money Municipal Short Term Index. This index reduces SHM’s duration down to just 3.13 years — about half of what MUB’s is. That shorter duration provides some level of interest rate protection.
The downside to going short is that you lose a lot of yield potential.
SHM’s 561 muni bonds only yields 0.93%. That’s a taxable equivalent yield of 1.37% if you’re in the highest tax bracket. But if the Fed raises interest rates by a lot over the next year or so, SHM will have an easier time rolling over its municipal bonds to higher-yielding ones, which will boost its yield in the longer term. In the meantime, it’s basically a place for short-term cash needs.
Expenses for SHM cost a cheap 0.2%.
Municipal Bonds — Market Vectors High-Yield Municipal ETF (HYD)
Need more tax-free income? If you’re willing to take on a bit more risk, the Market Vectors High-Yield Municipal ETF (HYD) is for you.
HYD tracks the non-investment grade swath of the municipal bonds market. These include one-off and special project revenue bonds as well as munis from towns with less-than-stellar credit. About 75% of its portfolio is in these bonds, while 25% is rated Baa/BBB-0, which is the lowest investment grade rating. ETF sponsor Van Eck cites this as needed for “liquidity and balance.”
By focusing on this side of the muni market, investors are treated to a monster tax-free yield.
HYD currently yields 4.93%. That’s a whopping 6.49% yield for someone in the 33% tax-bracket and a huge 7.2% for someone in 39% bracket. Now, some of HYD’s muni bonds are subject to the AMT — around 12% — which can pose other problems for higher earners. However, it’s still the easiest way to get big tax-free income from municipal bonds.
Expenses for HYD run 0.35%.
Municipal Bonds — Pimco Intermediate Municipal Bond Active ETF (MUNI)
Despite “Bond King” Bill Gross jumping ship, Pimco still runs a pretty decent bond investment shop. Case in point: its PIMCO Intermediate Municipal Bond Active ETF (MUNI).
Unlike the other muni ETFs on this list, MUNI is an actively managed fund. As such, manager Joseph Deane can pick and choose which bonds to hold. In this case, Deane and Pimco have continued to focus on “quality” versus yield. That includes rigorous credit analysis to unlock value from its holdings. It also results in a more concentrated portfolio of holdings. MUNI only owns 168 different municipal bonds.
As such, MUNI only yields 2.07%, which is still not too shabby, considering the taxable equivalent yields is around 3.09% for an investor in the 33% tax-bracket.
The idea is that, if things get dicey, MUNI should outperform the indexes due to its focus on quality. So far, performance has been about even. But, we’ve also had one heck of a bull market in municipal bonds since MUNI’s inception.
For the longer term, MUNI should outperform and makes a fine actively managed municipal bond choice for investors. Expenses run a cheap 0.35%.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.