While there are numerous strategies to optimize investment returns, one of the simplest yet most effective tactics is asset location, especially for those in a high tax bracket.
This refers to the practice of strategically placing investments in accounts based on their tax treatment to maximize returns after taxes. By understanding the nuances of the tax system, investors can position themselves to capitalize on assets that come with favorable tax treatments.
For example, placing real estate investment trusts, or REITs, in a Roth IRA can yield tax benefits since REIT dividends are generally taxed as regular income. Similarly, by housing low-dividend-paying, growth-oriented funds in a taxable brokerage account, investors can defer paying taxes on potential capital gains until they’re sold.
When it comes to bond funds, these are often best kept in tax-advantaged accounts because interest income from bonds is typically taxed at ordinary income rates, making them less tax-efficient in taxable accounts.
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However, not all bonds are created equal when it comes to tax efficiency. Enter the municipal bond. These bonds often come with a distinct advantage: The interest income they generate is typically exempt from federal taxes and, in some cases, from state and local taxes if the investor resides in the issuing state.
“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. By buying a municipal bond, investors are essentially acting as lenders to local government entities.
As a type of government-issued bond, municipal bonds typically offer a high credit rating. “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.”
Despite their appeal, diving into the municipal bond market can be difficult for laypersons. Purchasing individual municipal bonds can prove to be complex, opaque and sometimes illiquid.
This is where mutual funds and exchange-traded funds, or ETFs, can be a boon. By outsourcing the selection and portfolio management to a municipal bond fund, investors can gain exposure to this asset class with reduced hassle and increased liquidity.
“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 tax-free municipal bond funds to buy in 2023:
| Fund | Expense ratio |
| Vanguard Tax-Exempt Bond Index Fund Admiral Shares (ticker: VTEAX) | 0.09% |
| Vanguard Short-Term Tax-Exempt Bond ETF (VTES) | 0.07% |
| Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX) | 0.17% |
| iShares National Muni Bond ETF (MUB) | 0.07% |
| iShares Short-Term National Muni Bond ETF (SUB) | 0.07% |
| SPDR Nuveen Bloomberg Municipal Bond ETF (TFI) | 0.23% |
| SPDR Nuveen Bloomberg Short Term Municipal Bond ETF (SHM) | 0.2% |
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.”
A great example of diversification in play is VTEAX, which tracks the Standard & Poor’s National AMT-Free Municipal Bond Index. By doing so, the fund provides exposure to over 7,600 municipal bonds with an average duration of 5.9 years and a current yield to maturity of 3.8%. The fund charges a 0.09% expense ratio and is also available in ETF form as the Vanguard Tax-Exempt Bond ETF (VTEB).
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. For example, a municipal bond fund with a 6.5-year average duration can be expected to lose 6.5% if rates rise by 100 basis points, all else being equal, while a fund with a 2.5-year duration would only be expected to lose 2.5%.
Investors conscious of the impact of rising rates can use VTES as an alternative to VTEAX or VTEB. This ETF tracks the S&P 0-7 Year National AMT-Free Municipal Bond Index, giving it a lower average duration of 2.4 years and a yield to maturity of 3.3%, while maintaining a high-quality portfolio with most of its holdings rated AA. VTES 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 types of municipal bond funds typically have a lower credit rating, reflecting a higher risk of default with their underlying holdings.
An example is VWAHX, which does not track an index. Instead, the fund is actively managed, investing 80% in investment-grade municipal bonds and 20% in non-investment-grade issues. By taking on higher credit risk, VWAHX provides a higher yield to maturity compared to VTEAX at 4.5%, but also takes on more interest rate risk with a duration of 7.9 years. The fund charges a 0.17% expense ratio.
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 prefer greater diversification can use MUB, which tracks the ICE AMT-Free U.S. National Municipal Index for a 0.07% expense ratio. This ETF currently holds over 5,600 issues averaging out to a 6.6-year duration and 4.1% yield to maturity. MUB is one of the most popular and liquid municipal bond ETFs on the market, with over $34 billion in assets and a 30-day median bid-ask spread of 0.01%.
iShares Short-Term National Muni Bond ETF (SUB)
Municipal bond investors interested in national diversification but desiring lower interest rate risk can buy MUB’s shorter-maturity cousin, SUB, for the same 0.07% expense ratio. This ETF tracks the ICE Short Maturity AMT-Free U.S. National Municipal Index, giving it a much lower average duration of 1.8 years. However, the yield to maturity also drops to 3.7%.
SUB is less popular than MUB, having attracted around $8.8 billion in assets. However, the ETF is still very liquid, with a 30-day median bid-ask spread of 0.01%, the same as MUB. As with MUB, SUB makes monthly distributions, which can be desirable for investors drawing on their portfolio for income. The ETF is also robust in terms of credit quality, with around 88% of its issues rated AA or AAA.
SPDR Nuveen Bloomberg Municipal Bond ETF (TFI)
The 2022 bond bear market had a silver lining for savvy investors: an opportunity for tax-loss harvesting. This involves selling an underperforming asset to realize a capital loss and immediately buying a different asset that isn’t substantially similar, thereby circumventing the 30-day wash sale rule. By doing so, investors remain invested while realizing tax benefits.
For example, investors could potentially tax-loss harvest TFI and MUB against each other, given that both ETFs offer similar exposure, but track different indexes. In the case of the former, TFI tracks the Bloomberg Municipal Managed Money 1-25 Years Index, which currently has an average duration of 7.2 years and a yield to maturity of 4.2%. The ETF charges a 0.23% expense ratio.
SPDR Nuveen Bloomberg Short Term Municipal Bond ETF (SHM)
The shorter maturity alternative to TFI from SPDR is SHM, which tracks the Bloomberg Managed Money Municipal Short-Term Index. With this, investors are currently receiving an average duration of 2.6 years and a yield to maturity of 3.6%, making it similar, but not completely identical, to SUB’s metrics. Keep in mind that this ETF charges a higher expense ratio compared to SUB at 0.2%.
The geographical exposure of the ETF’s underlying bond issues is mostly concentrated in California and New York at 21% and 18%, respectively. Most of the bonds are issued by local or state governments, with some water and sewer, education, transportation and power exposure. The ETF is also slightly less liquid than SUB, with a 30-day median bid-ask spread of 0.02%.
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 10/11/23: This story was previously published at an earlier date and has been updated with new information.
