With the new year now into full swing, it can mean only one thing — tax season is upon us. That’s a big bummer for a lot of reasons.
For the majority of us, regardless of the political rhetoric and who ultimately wins the upcoming election, we are going to be sending a much bigger check to the IRS this year and every year going forward.
And while there are plenty of ways investors can lower their tax bills — qualified dividends, tax loss selling — there is only one that promises big yields and ZERO taxes.
We’re talking about municipal bonds of course.
Municipal bonds, or munis as they are typically called, are issued by local and state governments to fund daily activities or finance special projects. They’re great investments for portfolios and higher earners because they offer investors tax-free income at the federal (and sometimes state) level. In a lot of cases, buying a boring municipal bond can be worth more than other high-yield bonds when taxes are taken into effect. This is called their taxable equivalent yield.
The problem is, buying individual municipal bonds can be a tricky and an expensive proposition. Which is why the best way to get your munis fix is through municipal bond exchange-traded funds.
That said, here are three municipal bond ETFs to help lower your tax bite.
ETFs to Play Municipal Bonds: Vanguard Tax-Exempt Bond ETF (VTEB)
Taxable Equivalent Yield: 4.25%
While the iShares National AMT-Free Muni Bond ETF (MUB) reigns supreme as the top municipal bonds ETF on the market, a newcomer may give it a run for its money. Index champion Vanguard finally launched an indexed municipal bonds fund and ETF after only offering active managed munis funds.
The Vanguard Tax-Exempt Bond ETF (VTEB) tracks the S&P National AMT-Free Municipal Bond Index. This benchmark tracks the wide range of investment grade municipal bonds and excludes those issued by U.S. territories. So no troublesome Puerto Rico debt in VTEB.
All in all, the fund holds 675 different munis. However, the benchmark does hold more than 10,000. As the fund grows in assets (currently it has around $150 million), it’ll include more and more of those bonds.
Performance for the municipal bonds ETF has been decent in its short life span. Since launching in August of last year, VTEB is up around 2.9%. That’s not too bad considering just how severely the market has tanked in that time. The yield is a tax-exempt 1.69%.
The real win for investors is that as a Vanguard run ETF, expenses for VTEB are non-existent. The municipal bonds ETF only costs 0.12%, or $12 per $10,000 invested to own.
ETFs to Play Municipal Bonds: SPDR Barclays Short Term Municipal Bond ETF (SHM)
Taxable Equivalent Yield: 1.26%
The problem with munis is that traditionally, they are long-dated bonds. The issue comes from the fact that Bond prices have an inverse relationship with regards to interest rates. Longer dated bonds feel this relationship more than shorter dated ones. With the Fed already cranking up the interest rates, long-dated muni portfolios could suffer.
Which is why the SPDR Barclays Short Term Municipal Bond ETF (SHM) could be a great pick.
SHM bets on the shorter end of the municipal bonds spectrum by tracking the Barclays Managed Money Municipal Short Term Index. This index of 611 investment grade munis features a duration of just 2.85 years. That shorter duration provides some level of interest rate protection. As the Fed raises, SHM should see its share price dip less than a longer-dated municipal bonds ETF.
However, going short isn’t without its drawbacks.
Just as with taxable short-term bond funds, the yield here isn’t that crazy. SHM only yields 0.73%. But remember that’s tax free. That measly yield is equal to a 1.29% dividend yield for those investors in the highest Federal income tax rate. That rate isn’t too bad when considering the safety of munis as an investment.
Expenses for the municipal bonds ETF are a cheap 0.2%.
ETFs to Play Municipal Bonds: Market Vectors High-Yield Municipal ETF (HYD)
Taxable Equivalent Yield: 7.13%
Just like the regular bond space, not all municipal bonds are created equal. Credit worthiness varies from state to state or town to town. That means that some issuers are considered “junk.” And just like regular taxable junk bonds, junk munis pay much higher coupons.
The Market Vectors High-Yield Municipal ETF (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. The vast bulk of its 1317 holdings are in the BBB to CCC credit quality swaths. That’s the lowest investment grade rating down toward pure junk.
However, for taking on that added risk of buying a bond that finances a town’s monorail, investors are handsomely compensated with HYD’s 4.31% dividend yield. That would be like earning over 7% for investors in the highest tax bracket. The downside is that some of HYD’s bonds are subject to the dreaded alternative minimum tax.
That can be a headache for super higher earners. Despite this risk, it’s still the best way for most investors to gain a huge tax-free dividend from municipal bonds.
Expenses of HYD run 0.35%.
As of this writing, Aaron Levitt did not hold a position in any 0f the aforementioned securities.