Muni Bond Funds: Safest Investment Options

Municipal bonds, or munis, are issued by state and local governments to raise money for public projects such as schools and roads. They are typically exempt from federal income tax, making them an attractive choice for investors in high tax brackets.

There are two types of muni bonds: general obligation (GO) bonds and revenue bonds. GO bonds are funded directly by tax revenues and are considered the safest type of municipal bond, but they often have the lowest interest rates. Revenue bonds are paid back with revenue from specific projects, such as a toll road or an entertainment centre.

When choosing a muni bond fund to invest in, it is important to consider the fund's credit quality, yield, and expense ratio. It is also important to diversify your investments to lower the chances of default risk. Here are some of the top muni bond funds to consider:

Muni bond funds vs taxable-bond funds

Municipal bonds, or muni bonds, are issued by state and local governments to raise money for public projects such as schools and roads. They are typically exempt from federal income tax, and in some cases, state and local taxes as well. This makes them an attractive choice for investors in high tax brackets.

Muni bonds are often considered a relatively safe investment due to their low historical default rate. However, they generally offer lower yields compared to taxable bonds. When deciding between investing in muni bond funds or taxable-bond funds, there are several factors to consider:

Tax Implications

One of the main advantages of investing in muni bonds is the tax benefits they offer. The interest earned on muni bonds is typically exempt from federal income tax, and in some cases, state and local taxes as well. This makes muni bonds particularly attractive to investors in high tax brackets, as they can effectively reduce their tax burden.

On the other hand, taxable-bond funds invest in fixed-income securities issued by governments and corporations. These bonds provide diversification benefits and can offer higher yields compared to muni bonds. However, investors need to pay taxes on the interest earned, which can reduce the overall return on their investment.

Risk and Diversification

Muni bonds are generally considered low-risk investments due to their low historical default rate. According to Moody's, the annual municipal bond default rate was about 0.03% between 2009 and 2014. In contrast, the corporate bond default rate is typically higher, at about 2.5% per year.

However, one disadvantage of investing in individual muni bonds is the lack of diversification, which can create unnecessary risks. In contrast, bond funds, including taxable-bond funds, offer greater diversification by investing in a variety of short-term, medium-term, and long-term bonds, as well as government and corporate bonds. This diversification reduces the default risk and increases liquidity, making bond funds a better option for long-term investments.

Suitability for Different Investors

Muni bonds are often a good investment for people with high incomes, especially those living in states with high income taxes. The tax exemptions offered by muni bonds can result in significant savings for these individuals.

On the other hand, taxable-bond funds may be more suitable for investors using tax-deferred accounts like IRAs or 401(k)s, as these accounts already have tax advantages. Additionally, investors in lower tax brackets may find that the higher yields offered by taxable bonds outweigh the tax benefits of muni bonds.

Calculating Returns

When comparing the returns of muni bonds and taxable bonds, it is important to consider the tax implications. A taxable bond with a higher yield may not necessarily provide a better return once taxes are taken into account.

To make a fair comparison, investors can use the tax-equivalent yield formula:

> Tax-Equivalent Yield = Tax-Free Yield / (1 – Tax Rate)

This formula allows investors to calculate the yield a muni bond must have to be equal to the yield of a taxable bond, taking into account the tax savings of the muni bond.

Examples of Muni Bond Funds and Taxable-Bond Funds

Muni Bond Funds:

• Vanguard Tax-Exempt Bond ETF (VTEB)
• Fidelity Tax-Free Bond Fund (FTABX)
• T. Rowe Price Tax-Free High Yield Fund (PRFHX)
• Vanguard High-Yield Tax-Exempt Fund Admiral Shares (VWALX)

Taxable-Bond Funds:

• American Funds Tax-Exempt Preservation Portfolio (TYEFX)
• Fidelity Investment Grade Bond Fund (FBNDX)
• T. Rowe Price Floating Rate Fund (PRFRX)
• JPMorgan Core Bond Fund (JCBUX)

Muni bond ETFs vs individual munis

Municipal bonds, or munis, are issued by state and local governments to fund various government projects. They are typically exempt from federal income tax, making them an attractive choice for investors in high tax brackets.

Municipal bond ETFs, or exchange-traded funds, are a type of investment fund that holds a basket of muni bonds. They offer several advantages over investing in individual muni bonds.

Diversification

Muni bond ETFs provide investors with a diversified portfolio of muni bonds, reducing the risk of default. With exposure to many municipal bonds, a single default would not significantly impact the ETF. Most muni bond ETFs maintain well-balanced portfolios, typically limiting a single bond's share of net assets to 2% or less.

Reduced Risk

The diversification offered by muni bond ETFs lowers the overall risk of the investment. Muni bond ETFs are also less volatile than individual munis, particularly for long-term bonds, where default risk is inherently higher.

Liquidity

Muni bond ETFs are more liquid than individual munis, providing investors with greater flexibility to buy or sell their holdings.

Tax Advantages

Like individual munis, muni bond ETFs offer tax advantages. Interest payments from muni bond ETFs are typically exempt from federal income tax and, in some cases, state and local taxes as well. This makes them especially attractive to investors in high tax brackets.

However, there are also some potential downsides to consider when investing in muni bond ETFs compared to individual munis.

Capital Losses

One disadvantage of muni bond ETFs is the potential for capital losses when interest rates rise. With individual munis, investors can hold the bond until maturity and get back their full capital investment.

Bid-Ask Spread

The bid-ask spread, or the difference between the buying and selling prices, can impact the returns of a muni bond ETF. A high bid-ask spread can substantially reduce the returns of the ETF.

In conclusion, while muni bond ETFs offer diversification, reduced risk, and liquidity, they may also come with the potential for capital losses and the impact of the bid-ask spread. Individual munis, on the other hand, may provide less diversification and higher default risk but offer the security of full capital repayment at maturity. The decision between investing in muni bond ETFs or individual munis depends on an investor's risk tolerance, tax considerations, and investment goals.

Muni bonds for high-income individuals

Municipal bonds, or munis, are issued by state and local governments to raise money for public projects such as schools, roads, and infrastructure. They are often exempt from federal taxes, and sometimes state and local taxes, too. This makes them an attractive investment for high-income individuals, who can benefit from the tax exemptions.

Municipal bonds are considered a relatively safe investment, with a very low rate of default. They are also less volatile than stocks or corporate bonds. However, they do carry a level of risk, including interest rate risk, call risk, liquidity risk, revenue source risk, credit and default risk, and inflation risk.

There are two main types of municipal bond: general obligation bonds and revenue bonds. General obligation bonds are funded directly by tax revenues, while revenue bonds are paid back with revenue from specific projects, such as tolls or rents.

When considering investing in municipal bonds, it is important to compare the yields of taxable investment-grade and government bonds. While municipal bonds offer tax advantages, they may provide a lower yield than other investments. Municipal bonds are best held in taxable accounts, as their tax advantages are reduced in tax-deferred accounts such as IRAs or 401(k)s.

• Vanguard Tax-Exempt Bond ETF (VTEB)
• Fidelity Tax-Free Bond Fund (FTABX)
• T. Rowe Price Tax-Free High Yield Fund (PRFHX)
• BlackRock Allocation Target Shares: Series E Fund (BATEX)
• Delaware National High-Yield Municipal Bond Fund Institutional Class (DVHIX)
• Vanguard High-Yield Tax-Exempt Fund Admiral Shares (VWALX)

Muni bond funds for retirees

Municipal bonds, or munis, are issued by state and local governments to fund various government projects. They are typically exempt from federal income tax, making them an attractive choice for investors in high tax brackets. In some cases, munis may also be exempt from state and local taxes.

Municipal bonds are often considered a good investment for retirees. They are generally a high-quality asset class with a very low historical default rate. They also tend to be much less volatile than stocks, making them ideal for capital preservation in retirement.

Vanguard Tax-Exempt Bond ETF (VTEB)

VTEB is an index fund that tracks the performance of a benchmark measuring the investment-grade U.S. municipal bond market. At least 80% of the fund's assets are invested in securities whose income is exempt from federal income tax. It has a 5-year annualized return of 1.1% and an expense ratio of 0.05%.

Fidelity Tax-Free Bond Fund (FTABX)

The Fidelity Tax-Free Bond Fund aims to provide a high current yield that is exempt from federal income tax. At least 80% of its assets are invested in investment-grade securities whose interest is exempt from federal income tax. The fund may engage in transactions that have a leveraging effect, magnifying gains and losses. It has a 5-year annualized return of 1.5% and an expense ratio of 0.25%.

T. Rowe Price Tax-Free High Yield Fund (PRFHX)

PRFHX seeks a high level of income that is exempt from federal income tax by investing in long-term municipal securities with low to upper-medium investment-grade. The fund invests a substantial portion of its assets in municipal "junk" bonds and may purchase bonds in default, as long as they don't account for more than 10% of its assets. It has a 5-year annualized return of 1.7% and an expense ratio of 0.67%.

BlackRock Allocation Target Shares: Series E Fund (BATEX)

This BlackRock fund aims to provide investors with higher federal tax-free income than other muni bond funds by buying both investment-grade and non-investment-grade municipal bonds. About half of the fund is invested in municipal "junk" bonds, and up to 10% of assets can be invested in distressed securities. It has a 5-year annualized return of 3.0% and a low expense ratio of 0.02%.

Vanguard High-Yield Tax-Exempt Fund Admiral Shares (VWALX)

VWALX invests in long-term municipal bonds with medium to high credit quality, aiming to earn 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. It has a 5-year annualized return of 1.9% and an expense ratio of 0.09%.

It is important to note that municipal bonds may not be suitable for all retirees, especially those in lower tax brackets. Additionally, they should be held in taxable accounts only, as retirement accounts such as 401(k)s and IRAs already have tax advantages.

Muni bond funds for Arizona residents

Municipal bonds, or munis, are a good way to preserve capital while generating interest. They are issued by state and local governments to fund public projects such as schools and roads. They are typically exempt from federal income tax, and in many cases, state and local taxes as well.

Municipal bonds are often considered a distinct asset class and are generally exempt from federal tax. They are also usually exempt from state tax if purchased by an in-state resident. Arizona, for example, has issued around $40 billion in municipal bonds.

• Fidelity Arizona Municipal Income Fund (FSAZX): This fund invests in debt obligations issued by a local government or entity in the state of Arizona, including revenue bonds and general obligation bonds.
• Nuveen Arizona Quality Municipal Income Fund (XNAZX): This fund also invests in Arizona municipal bonds, offering attractive after-tax yields to investors.
• ARIZONA TAX-EXEMPT FUND (NOAZX): This fund offers tax advantages to Arizona residents, with income typically exempt from federal and state income taxes.
• Fidelity® Arizona Municipal Income Fund: This fund, offered by Fidelity, seeks to provide a high level of current income exempt from federal income tax and Arizona personal income tax. It normally invests at least 80% of its assets in Arizona municipal securities.

When considering municipal bond funds, it is important to keep in mind that they are generally most beneficial for those in high tax brackets. Additionally, they are best suited for taxable accounts, rather than retirement accounts like 401(k)s and IRAs, which already have tax advantages.

Frequently asked questions