After maximizing contributions to tax-advantaged accounts like a Roth IRA or 401(k), most investors will begin contributing to a taxable brokerage account. In general, the same principles for asset allocation still apply here — stocks drive returns but carry the majority of the risk, while bonds provide protection and stable income. However, investors who further optimize for tax efficiency can significantly boost their returns.
A great way to tweak fixed-income holdings to become more tax efficient is by holding municipal bonds.
“These are debt instruments issued by states, cities, counties and other governmental entities to raise funds to pay for public projects such as roads, bridges and schools,” says Nathan Will, principal and head of municipal credit research at Vanguard. “Their interest income is generally exempt from federal, state and sometimes local taxes if the investor resides in the state of issuance.”
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In the bond hierarchy, municipal bonds rank somewhere between U.S. government Treasurys and investment-grade corporate bonds in terms of credit risk.
“Municipal bonds are generally a high-quality asset class with a very low historical default rate,” Will says. “What sets them apart is the combination of strong credit fundamentals and the opportunity to earn tax-exempt income.”
However, the world of bonds can be difficult for layperson investors to delve into, given the myriad issuers, credit ratings and bond metrics that need to be understood. For a far more hands-off approach, investors can outsource the painstaking bond analysis to professional mutual fund and exchange-traded fund, or ETF, managers.
“There are several advantages to using a fund structure for investing in municipal bonds,” says Stuart Gillin, investment advisor at Baker Boyer Bank. “Municipal bond funds provide diversification that can be difficult for investors to achieve on their own, and are more liquid than individual bonds.”
When selecting a municipal bond fund, Gillin suggests assessing two risks: default risk and interest rate risk. “This means paying close attention to the overall credit quality and duration of the municipal bond fund’s portfolio and tailoring it to your individual needs,” he says.
Will agrees with Gillin, noting: “Choosing an appropriate municipal bond fund or ETF will depend on a number of factors specific to an individual investor, which include an investor’s time horizon, risk tolerance and federal, state and local tax considerations.”
“Municipal bonds are generally a high-quality asset class with a very low historical default rate.” – Nathan Will, principal and head of municipal credit research at Vanguard
Here’s a look at seven of the best municipal bond mutual funds and ETFs on the market right now:
| Muni Bond Fund | Expense Ratio |
| Vanguard Tax-Exempt Bond Index Fund Admiral Shares (ticker: VTEAX) | 0.09% |
| Vanguard Tax-Exempt Bond ETF (VTEB) | 0.05% |
| Vanguard Short-Term Tax-Exempt Bond ETF (VTES) | 0.05% |
| iShares National Muni Bond ETF (MUB) | 0.07% |
| iShares Short-Term National Muni Bond ETF (SUB) | 0.07% |
| Nuveen High Yield Municipal Bond Fund (NHMRX) | 0.72% |
| Schwab Opportunistic Municipal Bond Fund (SWHYX) | 0.5% |
Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX)
“First and foremost, investors in municipal mutual funds enjoy the benefits of diversification, as these funds are invested in hundreds, sometimes thousands, of individual bonds,” Will says. “In the event there is an adverse credit event, it will generally only affect a small part of the portfolio due to the effects of broad diversification and the expertise of a firm’s credit teams.”
A highly diversified, one-size-fits-all pick here is VTEAX. This mutual fund holds over 6,000 municipal bonds by tracking the Standard & Poor’s National AMT-Free Municipal Bond Index via a sampling technique. VTEAX’s perks include exemptions from both federal income taxes and the federal alternative minimum tax, a competitive yield to maturity of 3.6%, and a low expense ratio of 0.09%, or $9 a year for every $10,000 invested.
Vanguard Tax-Exempt Bond ETF (VTEB)
Investors who favor high liquidity and the ability to buy and sell throughout the day can opt for the ETF equivalent of VTEAX, which is VTEB. While VTEAX requires a $3,000 minimum investment like all Vanguard Admiral Shares mutual funds, the requirement for investing in VTEB is simply the price of a single share. As of April 11, 2023, that runs at around $50, making VTEB very capital efficient.
Aside from its structure, VTEB is functionally identical to VTEAX. It also tracks the Standard & Poor’s National AMT-Free Municipal Bond Index using a sampling technique, holds the same 6,000-plus bonds, and has an identical yield to maturity of 3.6%, which is the weighted average yield of all the bonds in the portfolio assuming they’re held to maturity.
However, VTEB does come in slightly cheaper with an expense ratio of 0.05%, which may be desirable for cost-conscious investors.
“Some municipal funds are designed to be state specific, which can be extra beneficial if you reside in a high-tax state like California or New York.” – Michael Ashley Schulman, partner and chief investment officer at Running Point Capital Advisors
Vanguard Short-Term Tax-Exempt Bond ETF (VTES)
Investors should also be sensitive to the duration of a fund, which measures its price sensitivity to interest rate changes. For example, a municipal bond fund with an average duration of 5.9 years like VTEB and VTEAX can be expected to lose 5.9% if interest rates rise by 1 percentage point. For risk-averse investors with short time horizons, keeping duration under control is important.
“In periods of rising interest rates, investors may want to explore a municipal bond fund with a shorter duration to mitigate the impact of interest rate volatility,” Will says. A possible pick here is VTES, which tracks the S&P 0-7 Year National AMT-Free Municipal Bond Index and offers much lower interest rate sensitivity. VTES also charges a 0.05% expense ratio.
[SEE: 7 ETFs to Buy as Interest Rates Rise.]
iShares National Muni Bond ETF (MUB)
“Some municipal funds are designed to be state specific, which can be extra beneficial if you reside in a high-tax state like California or New York,” says Michael Ashley Schulman, partner and chief investment officer at Running Point Capital Advisors. “However, this approach reduces the diversification achieved by investing in a national diversified municipal bond fund.”
Investors who favor maximum diversification can opt for the national approach by investing in MUB. This ETF tracks the ICE AMT-Free US National Municipal Index, which holds over 5,400 municipal bonds from all across the country. In terms of metrics, MUB features an intermediate effective duration of 6.4 years, an average yield to maturity of 2.9% and a 0.07% expense ratio.
iShares Short-Term National Muni Bond ETF (SUB)
Because MUB tracks a different index than VTEB, but has similar overall holdings and portfolio characteristics, investors can use both ETFs as tax-loss harvesting partners. For investors that prefer shorter-duration ETFs like VTES, a possible tax-loss harvesting partner is SUB, which is basically the shorter-duration version of MUB. In essence, SUB is to MUB as VTES is to VTEB.
By tracking more than 2,900 municipal bonds via the ICE Short Maturity AMT-Free US National Municipal Index, SUB manages to achieve a low effective duration of just 1.9 years. If interest rates rose by 1 percentage point, SUB would be expected to lose just 1.9% in value, all else being equal. The ETF features an average yield to maturity of 2.4% and also charges a 0.07% expense ratio.
Nuveen High Yield Municipal Bond Fund (NHMRX)
“The overall credit quality of a municipal bond fund chosen should reflect the investor’s risk tolerance,” Will says. “For example, a high-yield municipal bond fund may provide more income and/or total returns but may carry more risk.”
For risk-seeking investors, a pick like NHMRX could be a good way to boost income and total return potential, and it has a five-star rating from Morningstar as of March 31, 2023.
This fund is actively managed, seeking to target undervalued municipal bonds that are not rated investment grade or are unrated altogether. In addition, NHMRX employs leverage to enhance yields via tender option bond transactions. This fund has a longer effective duration of 13.6 years, and currently uses around 28.3% effective leverage. It is also pricey, charging a 0.72% expense ratio.
Schwab Opportunistic Municipal Bond Fund (SWHYX)
Most municipal bond funds are passively managed. That is, they either replicate or sample the holdings of a benchmark index. While they are unlikely to underperform the index, they have virtually no chance of beating it either. For investors looking for the ability to beat the index, an actively managed municipal bond fund like SWHYX could be a possible alternative.
SWHYX’s fund management team is free to pursue municipal bonds of all maturities and credit quality, including those rated below investment grade, to try and beat its benchmark: the Bloomberg Municipal Bond Index. However, at least 80% must be invested in investment-grade municipal bonds at all times. The fund has an average yield to maturity of 4.2%, an effective duration of 9 years and an expense ratio of 0.5%.
[READ: 10 ETFs to Build a Diversified Portfolio.]
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 04/12/23: This story was previously published at an earlier date and has been updated with new information.
