Muni bond funds offer safety and yield, plus tax advantages.
Treasury and corporate bonds may be popular among investors seeking safety and higher yields respectively, but what about tax efficiency? For investors looking to shield more of their returns from Uncle Sam, municipal bonds can offer an enticing alternative in a taxable account. These bonds are issued by state, county or city governments to fund public infrastructure projects, which can include the likes of schools, roads and bridges. They’re usually rated investment grade and tend to be a great choice for reducing volatility and drawdowns in a portfolio. The main benefit of municipal bonds is their exemption from federal taxes, and occasionally state taxes if the investor lives in the state that issued the bond. A great way to invest in a diversified portfolio of municipal bonds is via a mutual fund or exchange-traded fund that holds different issuers. Here are the seven best municipal bond funds to buy today.
Vanguard Tax-Exempt Bond Index Fund Admiral Shares (ticker: VTEAX)
A straightforward, low-cost and transparent way of investing in municipal bonds is via VTEAX, which tracks the Standard & Poor’s National AMT-Free Municipal Bond Index. This fund uses a sampling technique to select 6,871 bonds from the index’s 13,125 holdings. The bonds in the index are screened for exemptions from both federal income taxes and the federal alternative minimum tax. With an intermediate duration of 5.8 years, VTEAX can be expected to lose 5.8% if interest rates rise by 1%, all else being equal, and vice-versa if interest rates fall. A confidence booster is that 21.5% of the fund’s bonds are rated AAA by Standard & Poor’s, with 55.8% held in AA-rated bonds. VTEAX currently pays a yield to maturity of 3.4%, which is the return an investor could expect if they held all of the underlying bonds to maturity. The fund costs an expense ratio of 0.09% and requires a $3,000 minimum initial investment.
Vanguard Tax-Exempt Bond Index Fund (VTEB)
Investors who prefer ETFs over mutual funds can opt for VTEB, which is essentially VTEAX in ETF form. Unlike VTEAX, shares of VTEB trade on an exchange, with their price updated throughout the day. The ETF version also offers a lower expense ratio of 0.05% with no minimum initial investment requirement. To buy VTEB, investors must have enough money for a single share, which traded for approximately $50 on Jan. 17. Otherwise, the ETF tracks the same underlying index, holds the same bonds with identical credit quality, has the same yield to maturity and possesses the same duration. Since its debut in August 2015, VTEB has grown steadily in popularity to hit $25.4 billion in assets under management, or AUM.
JPMorgan Tax Aware Real Return Fund Class A (TXRAX)
Both VTEB and VTEAX are passively managed, in that their portfolio tracks an externally provided index. Investors who prefer a more active approach when it comes to municipal bond investing can select TXRAX. This fund combines a portfolio of municipal bonds with derivatives called inflation swaps. TXRAX uses these swaps in conjunction with tactical trades to minimize the effects of inflation. Combined with its lower average duration of 4.3 years, this helped TXRAX minimize its losses in 2022 to 6.2%, compared with VTEB’s loss of about 8%. The fund also possesses a higher yield to maturity of 4.1%, though the active management comes at the cost of much greater turnover, at 68%. This, combined with the use of swaps, leads to TXRAX’s comparatively high expense ratio of 0.75%. Investors interested in TXRAX should consider whether the fund’s strategy and objectives are worth the additional fees.
Fidelity Tax-Free Bond Fund (FTABX)
Investors on Fidelity’s platform have access to FTABX, which invests in bonds exempt from federal income tax and does not normally invest in bonds subject to the federal alternative minimum tax. The top issuers when it comes to FTABX’s holdings include agencies in New Jersey, Illinois and Washington. With a duration of 7.3 years, FTABX is more sensitive to interest rate movements than VTEAX or TXRAX. It also has a significantly lower allocation to AAA-rated bonds, with the majority of its holdings rated AA and A instead, making for an overall lower credit quality. To buy FTABX, investors will need to invest a minimum of $25,000. The fund charges a 0.25% net expense ratio.
iShares National Muni Bond ETF (MUB)
A popular tax-loss harvesting candidate for VTEB is MUB, due to their similar historical performance yet differing indexes. MUB tracks the ICE AMT-Free US National Municipal Index, which currently sports 5,538 federal tax-exempt bonds. Compared to VTEB, MUB has a slightly longer duration of 6.3 years and a lower average yield to maturity of 3%. In terms of its portfolio, 25.6% of its holdings are rated AAA, while the majority, or 56.5%, are rated AA. The largest issuers in MUB include agencies from New York, California and Texas. MUB is fairly popular, with more than $33 billion in AUM. The ETF charges a 0.07% expense ratio.
iShares Short-Term National Muni Bond ETF (SUB)
Municipal bond investors worried about the effects of rising interest rates can opt for a shorter-maturity ETF like SUB. This ETF tracks the ICE Short Maturity AMT-Free US National Municipal Index, which holds federal tax-exempt bonds with a much shorter average duration of 1.9 years. All else being equal, a 1% increase in interest rates will cause SUB to lose only 1.9% in value. The downside is a slightly lower yield to maturity of 2.4%. However, investors seeking a muni bond ETF with higher credit quality might like SUB given that 44.7% of its holdings are rated AAA, while 43.6% are rated AA. Like MUB, SUB also charges a 0.07% expense ratio.
VanEck Short High Yield Muni ETF (SHYD)
Not all municipal bonds are investment grade. Those who are willing to risk the lower credit quality of non-investment-grade bonds can receive higher yields. An example is SHYD, which holds 626 federal tax-exempt bonds screened for short maturities and high yields. Currently, SHYD has a yield to maturity of 4.6% and an effective duration of 4 years. Junk bonds, or bonds generally rated BB and below, make up about 25% of its portfolio, with another 33.7% not rated at all. Thus, the ETF is best suited for medium-risk investors seeking higher-than-average tax-efficient income. SHYD charges a 0.35% expense ratio.
7 best tax-free municipal bond funds:
— Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX)
— Vanguard Tax-Exempt Bond Index Fund (VTEB)
— JPMorgan Tax Aware Real Return Fund Class A (TXRAX)
— Fidelity Tax-Free Bond Fund (FTABX)
— iShares National Muni Bond ETF (MUB)
— iShares Short-Term National Muni Bond ETF (SUB)
— VanEck Short High Yield Muni ETF (SHYD)
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7 Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 01/17/23: This story was previously published at an earlier date and has been updated with new information.
