Owning a municipal bond fund is a superb way to receive income free of federal tax obligations. And if you buy a fund that owns bonds from your state of residence, you’ll also enjoy freedom from state taxes.
So, what is a municipal bond fund?
A municipal or muni bond fund is a mutual or exchange-traded fund that owns debt securities issued by a state, municipality or county. These securities are akin to loans issued to secure funding for projects within the region that will benefit the public — things like funding bridges, highways or schools. When you buy a muni bond fund, you’re lending money to the issuer in exchange for regular dividend payments. Unlike corporate bond income, municipal bond dividends are federal tax-free. If the bonds fund projects within your state, the income will also be free of state taxes.
Should interest rates decline, the value of the bond fund will rise adding capital appreciation to the income payments.
You may wonder whether the return on the municipal bond is ultimately better than that of a similar corporate bond. Use an online tax-equivalent yield calculator to determine whether muni or corporate bonds will result in lower tax obligations.
The following muni bond funds are designed to provide income which is federally tax free. For both state and federal tax savings, look for specific funds that are designed for high tax states like New York and California.
Best Muni Funds: iShares National Muni Bond ETF (MUB)
Expense Ratio: 0.07%, or $7 per $10,000 invested annually.
Founded in 2007, Best Muni Funds: iShares National Muni Bond ETF (NYSEARCA:MUB) tracks the returns of the S&P National AMT-Free Municipal Bond Index. With over 4,000 bonds, investors can be assured of broad diversification. Should an issuer default, there will be negligible impact on the fund’s returns or value.
Due to its popularity, MUB trades around one million shares per day, ensuring liquidity and minimal spread between the bid and ask prices. With the 0.07% management fee most of the investment goes directly into the bonds, not to the fund managers.
Most of the bonds were issued in New York, California, Texas, New Jersey, Massachusetts, Illinois and Washington. This means that investors from those states will receive an additional tax break on their state income taxes. The fund currently yields 2.4%, which is free of federal taxes. For an investor in the 28% federal tax bracket, that is equivalent to a 3.361% taxable corporate bond yield.
Vanguard High-Yield Tax-Exempt Fund Investors Shares (VWAHX)
Expense Ratio: 0.17%
For the aggressive investor seeking higher tax-free returns, Vanguard High-Yield Tax-Exempt Fund Investors Shares (MUTF:VWAHX) is tough to beat. The fund has a reasonable 0.17% expense ratio. Note that lower credit quality and greater risk accompanies this higher-yield fund.
The credit quality of the portfolio includes 23% AA, 35% A and 20% BBB bonds, with 9% of the bonds not rated. The fund holds approximately 2,700 bonds with an average duration of 6.2 years.
This fund is an appropriate addition to a diversified fixed income allocation for investors comfortable with an allocation to lower and non-rated bonds. As is the case with all bonds and bond funds, should interest rates trend upward, the bond’s value will decline, offsetting the higher dividends.
SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF (SHM)
Investors worried about rising interest rates might consider the SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF (NYSEARCA:SHM), as the shorter duration will make this fund less sensitive to interest rate movements. So, when interest rates start to ascend, the fund’s value will fall less than those funds which own longer term bonds.
Founded in 2007, the fund is part of the SPDR State Street Global Advisors and tracks the Bloomberg Barclays Managed Money Municipal Short Term Index. SHM owns nearly 1,000 bonds. The fund’s 35% holdings turnover is somewhat higher than that of the first two funds, which is to be expected with a shorter term ETF.
SHM owns 28% AAA bonds and the bulk of the remainder in high quality AA issues. The 1.4% yield equates to a 1.958% taxable yield. In contrast, the SPDR Portfolio Short Term Corporate Bond ETF (SPSB) currently yields 2.77%, making it a higher return fund for the taxpayer in the 28% marginal tax bracket. Yet, the corporate SPSB is riskier than SHM and includes lower quality bonds than the muni fund with 42% of the portfolio invested in BBB rated issues.
For investors seeking both investment management and muni bond investing Betterment and Personal Capital offer opportunities for tax-free investments along with varying degrees of financial oversight.
Higher-tax-bracket individuals might explore municipal bond funds to boost their after tax income. The muni bond fund returns are easily compared with similar taxable bonds using a tax equivalent yield calculator.
Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance; An Encyclopedia of Modern Money Management and two additional money books. She is CEO of Robo-Advisor Pros.com, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Finance.com. Follow her on twitter @barbfriedberg and @roboadvisorpros. As of this writing, she did not hold a position in any of the aforementioned securities.