Sometimes, the best way to earn better investment returns is by keeping expenses under control. Usually, this means keeping fees low, whether in terms of minimizing fund expense ratios or eliminating sales loads. By reducing these as much as possible, investors can maximize long-term net returns, which allows for greater compounding potential.
However, a significant source of drag that often goes unnoticed is taxation on investment returns, whether in the form of dividends, income or capital gains. Outside of tax-advantaged accounts like a Roth IRA or 401(k), taxes can quickly eat into investment returns. This is all the more important for investors who fall into the highest income brackets.
To remedy this, investors can access a variety of assets designed to be particularly tax efficient. Popular instruments in this category are 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.
In general, the interest income paid by municipal bonds tends to receive much more favorable tax treatment. “Their interest income is generally exempt from federal, state and sometimes local taxes if the investor resides in the state of issuance,” Will says.
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In terms of credit quality, municipal bonds sit somewhere between investment-grade corporate bonds and Treasurys in terms of default 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.”
While investors can buy individual municipal bond issues, a more convenient alternative is to buy a municipal bond mutual fund or exchange-traded fund, or ETF. By doing so, investors can avoid the trouble of valuing an individual bond or assessing its credit risk.
“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.”
Here’s a look at seven of the best municipal bond mutual funds and ETFs to buy in 2023:
| Bond Fund | Expense Ratio |
| Vanguard Tax-Exempt Bond ETF (ticker: VTEB) | 0.05% ($5 yearly per $10,000 invested) |
| Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX) | 0.09% |
| Vanguard Short-Term Tax-Exempt Bond ETF (VTES) | 0.07% |
| iShares National Muni Bond ETF (MUB) | 0.07% |
| iShares Short-Term National Muni Bond ETF (SUB) | 0.07% |
| Pimco Municipal Bond Fund (PFMIX) | 0.44% |
| Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX) | 0.17% |
Vanguard Tax-Exempt Bond ETF (VTEB)
“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,” Will says. While each investor will have their own preferences, some municipal bond funds stand out in terms of popularity. An example is VTEB, which has attracted $29.2 billion in assets.
By tracking the Standard & Poor’s National AMT-Free Municipal Bond Index, VTEB provides exposure to more than 7,400 municipal bonds of multiple maturities. All this comes at a low expense ratio of 0.05%, or around $5 per $10,000 invested. As an ETF, the minimum cost of investing in VTEB is simply the cost of a single share, which currently sits at around $50.
Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX)
“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.”
For those looking for the ability to automate recurring investments in varying increments, the mutual fund version of VTEB, VTEAX, may offer greater flexibility. This fund tracks the same index and thus has a virtually identical portfolio. However, it does charge a higher expense ratio of 0.09%, though this is still manageable at just $9 annually for every $10,000 invested. In addition, investors should note that VTEAX requires a $3,000 minimum investment.
Vanguard Short-Term Tax-Exempt Bond ETF (VTES)
“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.
Bond prices move inversely to interest rate changes, with duration governing the magnitude of the movement. Therefore, longer-duration municipal bond ETFs stand to lose the most when interest rates rise.
For example, intermediate municipal bond funds with an average duration of 5.8 years like VTEB and VTEAX will lose 5.8% should rates rise by one percentage point, all else being equal. For investors concerned about further rate hikes, a good alternative could be VTES. By tracking the S&P 0-7 Year National AMT-Free Municipal Bond Index, VTES limits its duration to 2.4 years. The ETF charges a 0.07% expense ratio.
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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.”
For national diversification, an ETF like MUB could be ideal. MUB tracks the ICE AMT-Free US National Municipal Index, which currently sports more than 5,400 holdings averaging a duration of 5.9 years. Currently, MUB is paying an average yield to maturity of 3.4%, which is the theoretical return expected should all of the ETF’s underlying bonds be held until maturity. MUB charges a 0.07% expense ratio.
iShares Short-Term National Muni Bond ETF (SUB)
By keeping multiple municipal bond ETFs that track different indexes on their watchlist, investors can build up a list of candidates to swap out periodically for tax-loss harvesting. For example, MUB can be used to tax-loss-harvest VTEB given their similar portfolio characteristics, but different indexes. For the shorter-duration VTES, a viable tax-loss harvesting partner could be SUB.
SUB tracks the ICE Short Maturity AMT-Free US National Municipal Index, which has just over 2,800 bonds with an average duration of 1.9 years, against an average yield to maturity of 3%. This is fairly similar to VTES, which has a duration of 2.4 years and a yield to maturity of 3.3%. SUB also charges an identical 0.07% expense ratio.
Pimco Municipal Bond Fund (PFMIX)
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. When it comes to managing risk, few firms have as much expertise as Pimco, a renowned fixed-income manager.
The firm’s flagship municipal bond fund is PFMIX, an actively managed fund. Unlike the previous funds, PFMIX does not track an index. Instead, Pimco’s fixed-income team selects and manages a portfolio that they believe will beat the Bloomberg Municipal Bond Index. The fund sports an average duration of 6 years and only holds investment-grade municipal bonds. PFMIX charges a 0.44% expense ratio, by far the highest on this list, owing to the fund’s active management.
Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX)
“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 investors willing to take on greater credit risk in exchange for higher yields, a viable alternative to investment-grade municipal bond funds may be VWAHX.
Unlike most Vanguard funds, VWAHX is actively managed. Currently, 78% of the fund is invested in investment-grade municipal bonds, while the remaining 22% is invested in non-investment-grade, or high-yield, municipal bonds. This results in a higher average yield to maturity of 4.4%, against a duration of 7.8 years. The fund charges a 0.17% expense ratio and has a $3,000 minimum investment requirement.
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 06/29/23: This story was published at an earlier date and has been updated with new information.
