Many bond investors meticulously analyze metrics such as yield to maturity, which reflects the total return anticipated on a bond if held until it matures, and duration, a measure of the bond’s sensitivity to changes in interest rates.
However, one aspect that often doesn’t receive enough attention is tax efficiency. Despite appearing minor, tax efficiency can significantly influence the net returns a bond investor ultimately realizes.
Take, for instance, the Vanguard Total Corporate Bond ETF (ticker: VTC). Over the trailing five years up to Dec. 31, 2023, this ETF delivered an annualized total return of 2.5%.
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Yet, this figure doesn’t account for the impact of taxes. If VTC was held outside of tax-sheltered accounts like a Roth IRA or 401(k), this return diminishes to just 1.2% after taxes, halving the investor’s gains.
This example underscores a crucial lesson: Tax efficiency is a vital consideration for bond investors, particularly those in higher income brackets. Federal and state taxes can substantially reduce the returns on a bond fund, highlighting the need for strategic investment choices to mitigate tax liabilities.
For investors who have already maximized their contributions to tax-advantaged accounts, one viable solution is to turn to funds 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.
Municipal bond funds invest in securities issued by municipalities, which are often exempt from federal taxes and, in some cases, state taxes for residents of the issuing state.
This tax-exempt status makes municipal bond funds an attractive and sought-after option for high-income investors seeking to optimize their after-tax returns while also providing safety of principal.
“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.”
By focusing on tax efficiency and incorporating municipal bond funds into their portfolios, investors can protect their earnings from significant tax erosion, ensuring a more favorable outcome for their fixed-income investments.
Here are seven of the best municipal bond mutual funds and exchange-traded funds, or ETFs, to buy:
| Fund | Expense ratio |
| iShares National Muni Bond ETF (MUB) | 0.05% |
| Vanguard Tax-Exempt Bond Index Fund Admiral Shares (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 California Muni Bond ETF (CMF) | 0.08% |
| iShares New York Muni Bond ETF (NYF) | 0.25% |
| Invesco Floating Rate Municipal Income ETF (PVI) | 0.25% |
iShares National Muni Bond ETF (MUB)
“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.” A great example of this in play is MUB, which holds over 5,600 municipal bonds.
MUB is a passive ETF, meaning that it seeks to replicate and track the composition and return of an external benchmark index. For MUB, the benchmark is the ICE AMT-Free U.S. National Municipal Index. Currently, investors can expect an average yield to maturity of 3.2% and an average duration of six years. The ETF is also very affordable, with a 0.05% expense ratio.
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.”
Vanguard’s flagship municipal bond mutual fund is VTEAX. This fund tracks the Standard & Poor’s National AMT-Free Municipal Bond Index, which gives it exposure to over 10,000 municipal bonds averaging a 3.4% yield to maturity and 5.6 years’ duration. It charges a 0.09% expense ratio. Investors can avoid the $3,000 minimum investment by opting for 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. The Vanguard municipal bond fund to consider for this role is VTES, which has a 2.4-year duration. All else being equal, a 100-basis-point hike in rates will only cause VTES to lose around 2.4% in value.
Currently, investors can expect a 2.9% yield to maturity from VTES’ portfolio of over 2,200 bonds, all of which are exempt from both the federal income tax and the federal alternative minimum tax. As an ETF, the minimum investment requirement is simply the price of a single share, which stood at around $100 as of Feb. 20. 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 funds hold bonds issued by municipalities with a higher probability of default. Thus, they pay higher yields to compensate for the greater credit risk.
Investors who are comfortable with these risks can use a fund like VWAHX to target higher tax-exempt income. Some 80% of this fund’s portfolio is held in investment-grade municipal bonds, while 20% can be allocated to non-investment-grade municipal bonds. VWAHX pays a 3.9% yield to maturity against a duration of 7.7 years and charges a 0.17% expense ratio.
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iShares California Muni Bond ETF (CMF)
“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.”
High-income residents of California can opt for a municipal bond ETF like CMF. This fund tracks the ICE AMT-Free California Municipal Index, which features bonds issued by entities like the University of California and the Los Angeles Department of Water & Power. CMF currently has a 3.1% yield to maturity, a 6.1-year duration and charges a 0.08% expense ratio.
iShares New York Muni Bond ETF (NYF)
The counterpart to CMF suitable for high-income investors residing in New York is NYF. This ETF tracks the CE AMT-Free New York Plus Municipal Index, which features over 600 bonds issued by entities like the New York Municipal Water Finance Authority, the Metropolitan Transportation Authority, and the Port Authority of New York and New Jersey for a 0.25% expense ratio.
Currently, investors can expect a 3.3% yield to maturity, along with an intermediate duration of 5.8 years. NYF has a decent overall credit quality, with around 15% rated A, 55% rated AA and 27% rated AAA. Like the previous funds, NYF also pays out income on a monthly basis. Over the past three years, this ETF has been a reliable low volatility pick, with a 7.1% standard deviation and 0.3 beta.
Invesco Floating Rate Municipal Income ETF (PVI)
A unique municipal bond fund to watch is PVI, which tracks the ICE U.S. Municipal AMT-Free VRDO Constrained Index. This ETF specializes in tax-exempt variable-rate demand obligations, or VRDOs, which unlike nominal municipal bonds reset their interest rates on a daily, weekly or monthly basis. Thus, the yields expected from these bonds “float” with prevailing short-term interest rates.
Despite being a more complex instrument compared to traditional municipal bonds, PVI’s portfolio still has many of the same features, including tax-exempt income and a high credit quality that is 54% AA rated bonds. Issuers in PVI include the Raleigh-Durham Airport Authority in North Carolina, the Louisiana Offshore Terminal Authority and the Bay Area Toll Authority in San Francisco. PVI charges a 0.25% expense ratio and has a 3.2% yield to maturity.
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 02/21/24: This story was published at an earlier date and has been updated with new information.
