While President Donald Trump has vowed to cut taxes and reformat the nation’s tax brackets/system, the promise is easier said than done. Taxes — and potentially higher taxes — are going to be a part for everyone’s vocabulary for a long time. That $1 trillion for infrastructure investments isn’t going to pay for itself.
Higher taxes poses a significant problem for investors looking for income from their portfolios. How do you get quality yields without sending a bigger piece of the pie to Uncle Sam?
The answer could lie in municipal bond funds.
Municipal bond funds, or muni bonds, are issued by state or local governments to support their day-to-day activities or to fund a particular project. The beauty for municipal bonds is that they are free of Federal income taxes and in some cases free from state/local taxes as well. For wealthy investors in higher tax brackets, municipal bond funds are a godsend. But really for any investor, muni bonds can do wonders to reduce their taxable liability.
And given how hard it is for the average investor to buy individual municipal bonds, the only answer is to get them through mutual funds and exchange-traded funds. Here are three municipal bond funds to buy for tax-free income.
Municipal Bond Funds to Buy for Tax-Free Income: Vanguard Tax-Exempt Bond ETF (VTEB)
Expenses: 0.12%, or $12 per $10,000 invested
Taxable Equivalent Yield at 35% Tax Bracket: 3.4%
After offering only actively managed municipal bond funds for decades, low-cost superstar Vanguard finally launched a series of indexed muni funds last year. For tax-sensitive investors, it was the best news since the invention of sliced bread.
Since the launch, the Vanguard Tax-Exempt Bond ETF (NYSEARCA:VTEB) has grown in assets and size. The ETF tracks the S&P National AMT-Free Municipal Bond Index. This benchmark follows the broad spectrum of investment-grade municipal bonds and excludes those issued by U.S. territories. So, no troublesome Puerto Rico debt in VTEB.
Currently, the fund holds more than 2,300 different muni bonds. Interesting to note, VTEB’s index is the same as the uber-popular iShares S&P Natnl AMT – Free Munpl Bd Fd (NYSEARCA:MUB).
Also interesting is that VTEB is cheaper than MUB regarding expenses. Owning MUB will set you back about $25 per year on a $10,000 investment. VTEB drops that number down to just $12. In the end, that’s more money in your pocket and faster compounding.
It also matters when it comes to returns. Last year when muni bonds were flat, VTEB managed to outperform MUB.
In the end, when it comes to indexed municipal bond funds, VTEB takes the cake.
Municipal Bond Funds to Buy for Tax-Free Income: T. Rowe Price Tax-Free High Yield (PRFHX)
Taxable Equivalent Yield: 5.92%
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.
When it comes to playing the “junkier” side of the sector, investors may want to skip the indexes and go with an actively managed municipal bond fund like the T. Rowe Price Tax-Free High Yield Fund (MUTF:PRFHX).
The gold-rated mutual fund seeks a balance between riskier municipal bonds and those at the top of the spectrum. Currently, about 62% of its portfolio is bonds rated BBB or lower. The rest is in investment-grade munis. By keeping one foot in the water and the other on dry land, PRFHX has been able to provide a slightly better yield than a regular municipal bond fund, such as the previously mentioned VTEB, without adding too much extra risk.
It also helps on the returns front. Since its inception in 1985, PRFHX has managed to return nearly 7% annually. That’s crazy good for any investment, let alone one tackling something as boring as muni bonds.
Expenses run just 0.69%.
Municipal Bond Funds to Buy for Tax-Free Income: Eaton Vance Municipal Income Trust (EVN)
Taxable Equivalent Yield: 9.97%
The best municipal bond funds could be closed-end funds (CEFs). CEFs are a quirky cousin of ETFs and mutual funds. And due to their structure — they have a set number of shares, but trade on the main exchanges — closed-end funds can and often do trade at a discount to their underlying values. That discount plus a slight bit of leverage means CEFs feature much larger yields than their respective funds.
Case in point, the eye-pooping 9.97% taxable equivalent yield on the Eaton Vance Municipal Income Trust (NYSE:EVN).
EVN owns a broad portfolio of munis with the vast bulk of its portfolio in investment-grade bonds. The key is the fund’s leverage. Like many CEFs, EVN has borrowed money via a type of preferred stock and used the proceeds to invest in higher yielding muni bonds. The difference in the cost associated with the leverage and the amount of interest income it receives goes right into investors pockets- tax-free.
Add in the EVN’s 2.76% discount to its net asset value, and you have a recipe for high-yielding success that Uncle Sam can’t touch.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.