Bond investing is a tried-and-true strategy for many who seek consistent income from their portfolios while potentially lowering volatility and drawdowns.
However, it’s essential for investors to recognize that not all bonds are created equal when it comes to taxation. Depending on their issuer, the income from bonds can be taxed at varying levels, ultimately affecting net returns.
For instance, U.S. Treasury bonds, which are essentially loans to the federal government, come with a unique tax benefit: Their interest income is exempt from state taxes. This can be a considerable advantage for investors living in high-tax states. However, the interest from Treasury bonds is still subject to federal income tax.
On the other hand, corporate bonds, which are loans to companies, don’t enjoy this level of tax preference. The interest income from corporate bonds is taxable at both the federal and state levels. Depending on your tax bracket and where you live, a significant portion of your corporate bond income can be eaten up by taxes.
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Enter 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.
Municipal bonds receive the most favorable tax treatment of all, paying interest income that is exempt from federal taxes. Moreover, if the bond is issued within the state where the investor resides, it can also be exempt from state and local taxes. For those in the highest tax brackets, especially those living in high-tax states, this can translate to a significantly higher effective yield than what’s seen on the surface.
Municipal bonds also offer a high level of credit quality, adding to their relative degree of safety. “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.”
To access municipal bonds, investors may find it advantageous to use a mutual fund or exchange-traded fund, or ETF, that holds a broad basket of them. This approach provides transparency, diversification and the benefits of professional bond selection and portfolio management.
“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 are seven of the best municipal bond funds to buy today:
| 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) | 0.07% |
| Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX) | 0.17% |
| Fidelity Municipal Bond Index Fund (FMBIX) | 0.07% |
| iShares National Muni Bond ETF (MUB) | 0.07% |
| Pimco Intermediate Municipal Bond Active ETF (MUNI) | 0.35% |
Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX)
“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. That being said, some municipal bond funds like VTEAX have gained popularity as a one-size-fits-all option thanks to low fees and high diversification.
At a 0.09% expense ratio, VTEAX would cost an investor an annual fee of just $9 assuming a $10,000 investment. By tracking the Standard & Poor’s National AMT-Free Municipal Bond Index, the fund holds over 7,600 municipal bond issues ranging in maturity from under one year to over 30 years, with 58.7% having a credit rating of AA. However, keep in mind the fund requires a $3,000 minimum investment.
Vanguard Tax-Exempt Bond ETF (VTEB)
“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 investors still seeking high diversification but looking to avoid the $3,000 minimum investment requirement of VTEAX, Vanguard offers VTEB as an alternative. Because it’s an ETF, the minimum investment requirement for VTEB is the price of a single share, which currently sits at around $50. Otherwise, the ETF tracks the same index. It also charges a lower expense ratio of 0.05%.
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. A bond fund’s duration determines the potential loss or gain corresponding to interest rate movements. The relationship between a bond’s price and interest rates is inverse — as rates rise, bond prices fall.
To mitigate this risk, investors can consider short-term municipal bond ETFs like VTES, which tracks over 1,000 issues represented by the S&P 0-7 Year National AMT-Free Municipal Bond Index. With an average duration of just 2.5 years, VTES can be expected to lose 2.5% in value should interest rates rise by 100 basis points, all else being equal. The ETF charges a 0.07% expense ratio.
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.” These funds invest in municipal bonds with credit ratings that fall below “investment grade,” i.e., lower than BBB from Standard & Poor’s.
That being said, investors do get compensated for the higher default risk with better yields. Consider VWAHX, which can invest up to 20% of its portfolio in non-investment-grade municipal bonds. Thanks to this, the fund currently pays a higher-than-average yield to maturity of 4.4%, which is the average return investors can expect if all of its underlying bonds are held to maturity. It charges a 0.17% expense ratio.
[READ: Understanding the Hidden Pitfalls of High-Yield Investments]
Fidelity Municipal Bond Index Fund (FMBIX)
“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 a broad, nationwide approach to municipal bond investing, consider FMBIX. This fund tracks the Bloomberg Municipal Bond Index, which holds municipal bonds issued by entities in California, New York, Texas, Illinois, New Jersey, Florida, Pennsylvania, Washington, Massachusetts and more. Fidelity offers FMBIX with no minimum required investment, no transaction fees and a 0.07% expense ratio.
iShares National Muni Bond ETF (MUB)
MUB offers investors an ETF alternative to FMBIX for broad national municipal bond exposure. By tracking the ICE AMT-Free U.S. National Municipal Index, the ETF provides exposure to over 5,400 municipal bonds issued around the country, with an intermediate duration of 6.3 years and an average yield to maturity of 3.6%.
The ETF is very popular, with over $32 billion in assets under management. It is also very liquid, with a minuscule 30-day median bid-ask spread of 0.01% and 30-day average volume of over 2.3 million shares, making it easy for investors to buy and sell at their desired price. MUB also comes close to the Vanguard municipal bond ETFs in terms of fees, with a 0.07% expense ratio.
Pimco Intermediate Municipal Bond Active ETF (MUNI)
Municipal bond index funds tend to have low fees, but there is a downside. These funds are constrained to tracking a benchmark index, meaning they cannot adjust their strategy or portfolio in response to events like rising interest rates. While this may not be a big deal over the long term, it can result in higher-than-desirable short-term volatility for investors.
To mitigate this, investors can buy actively managed municipal bond ETFs like MUNI. Managed by Pimco, a renowned fixed-income asset manager, MUNI is able to fine-tune its duration and credit quality exposure based on Pimco’s research and expertise. However, this does come with higher fees, with MUNI charging a 0.35% expense ratio, or seven times that of VTEB.
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 08/22/23: This story was previously published at an earlier date and has been updated with new information.
