While equities get the most attention in the investment world, municipal bonds can play an important role in a diversified portfolio and can come with attractive tax benefits. Municipal bonds, or munis, are issued by state and local governments to finance various government projects. Unlike most bonds, they are generally exempt from federal income tax, making them an attractive choice for investors in higher tax brackets.
Here’s what else you need to know about municipal bonds and some top funds to consider for your taxable portfolio.
What are municipal bonds and how do they work?
Municipal bonds are issued by state and local governments to raise funds for public projects such as schools and roads. General bonds are used for projects that are unlikely to generate revenue, while revenue bonds are repaid with revenue from specific projects, such as a toll road or an entertainment center.
Although municipal bonds may not seem like the most exciting investment, they generally do not benefit from any federal taxes. Plus, in many cases, you may not owe state or local taxes either. Because of this tax advantage, a lower yield on a municipal bond may actually be more attractive than a higher yielding taxable bond once you adjust for the tax savings.
Here’s how it works: Imagine making a lot of money with a federal income tax rate of 37% and a state tax rate of 7%. You are considering a municipal bond with a 3% yield and a taxable bond with a 4% yield.
Tax equivalent yield = Interest rate / (1 – tax rate)
You’ll see that the municipal bond has a tax-equivalent yield of nearly 4.8% based only on the federal tax savings, and the tax-equivalent yield rises to 5.4% when you factor in the additional tax savings. government, both of which exceed the 4% return on the taxable bond.
Investors in higher tax brackets benefit the most from the tax advantages of municipal bonds, but even if you’re in a lower tax bracket, munis may be right for your portfolio. In general, municipal bonds have a low risk of default and are less volatile than corporate bonds or riskier stocks.
Although you can invest in individual municipal bonds, it is easier to invest in a municipal bond fund. Investing in a fund means you don’t have to research every individual investment and you’ll get the benefits (such as reduced risk) of holding a diversified portfolio of municipal bonds. Here are some funds to consider.
Top Municipal Bond Funds
Data below as of July 12, 2022.
Vanguard Tax-Exempt Bond ETF (VTEB)
The Vanguard Tax-Exempt Bond ETF is an index fund that seeks to track the performance of a benchmark index measuring the investment-grade US municipal bond market. At least 80% of the fund’s assets are invested in securities whose income is exempt from federal income tax.
Annualized return over 5 years: 1.7%
Spending rate: 0.05 percent
Total assets: $18.1 billion
Fidelity Tax-Free Bond Fund (FTABX)
Fidelity Tax-Free Bond Fund aims to provide a high current yield that is exempt from federal income tax. The fund invests at least 80% of its assets in high quality securities whose interest is exempt from federal income tax. The fund may engage in trades that leverage the fund, magnifying gains and losses.
Annualized return over 5 years: 1.9%
Yield: 2.7 percent
Spending rate: 0.25 percent
Total assets: $3.1 billion
T. Rowe Price Tax-Free High Yield Fund (PRFHX)
The T. Rowe Price Tax-Free High Yield Fund seeks a high level of income that is exempt from federal income tax by investing in long-term municipal securities with an upper low to medium investment grade rating. The fund invests a significant portion of its assets in “junk” municipal bonds and can buy defaulted bonds as long as they do not represent more than 10% of assets.
Annualized return over 5 years: 2.1 percent
Spending rate: 0.63 percent
Total assets: $4.6 billion
BlackRock Allocation Target Shares: Series E (BATEX) Funds
This BlackRock fund aims to provide investors with higher tax-free federal income than other municipal bond funds that invest in quality securities by buying both investment-grade and sub-investment-grade municipal bonds. About half of the fund is invested in “junk” municipal bonds and up to 10% of the assets may be invested in distressed securities.
Annualized return over 5 years: 4.1%
Spending rate: 0.05 percent
Total assets: $341.5 million
Delaware National Municipal High Yield Bond Fund Institutional Class (DVHIX)
The Delaware National High-Yield Municipal Bond Fund invests in mid- and lower-quality municipal bonds to generate high current income that is exempt from federal income tax. The fund currently holds nearly 20% of its assets in Puerto Rican debt, while another 11% of the fund’s investments come from California.
Annualized return over 5 years: 3.4%
Spending rate: 0.60 percent
Total assets: $1.8 billion
Vanguard High Yield Tax-Exempt Fund Admiral Shares (VWALX)
The Vanguard High-Yield Tax-Exempt Fund invests in long-term municipal bonds with medium to high credit quality and aims to generate high and sustainable current income exempt from federal income tax. The portfolio has an average maturity of 10 to 25 years and focuses on sectors representing relative value.
Annualized return over 5 years: 2.5 percent
Spending rate: 0.09 percent
Total assets: $15.3 billion
At the end of the line
While municipal bonds probably won’t generate as high returns as other investments such as stocks, they can provide tax benefits to your portfolio, especially if you’re in a high tax bracket. Because of these tax advantages, it makes sense to hold municipal bond funds only in taxable accounts, and not in retirement accounts such as 401(k)s and IRAs, which already have tax advantages.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Further, investors are advised that past performance of investment products does not guarantee future price appreciation.