Most investors recognize the fundamental role of bonds in a portfolio. They provide a steady income stream and typically exhibit lower volatility compared to equities.
However, the tax implications of bond investments can introduce some complexities that are crucial to understand, especially for income investors who largely focus on equities.
For instance, dividends from U.S. stocks, known as qualified dividends, are taxed favorably at rates applicable to long-term capital gains, which are generally lower than rates for ordinary income.
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In contrast, interest income from corporate bonds is taxed at ordinary income rates at both federal and state levels in the year it is received, which can significantly increase the tax burden.
Meanwhile, U.S. Treasury securities provide a slight tax break as they are exempt from state taxes, though they remain subject to federal taxes.
Municipal bonds, or “munis,” represent the most tax efficient option. Investing in these bonds means lending money to local government entities to support essential services and infrastructure projects.
“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.
These bonds offer a tax advantage because their interest income is typically exempt from federal income taxes and, in many cases, state and local taxes if the investor resides in the state where the bond is issued. Overall, they are considered to be a fairly conservative investment.
“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.”
Investing in municipal bonds through mutual funds or exchange-traded funds (ETFs) further adds layers of transparency, liquidity and the convenience of monthly distributions.
However, investors should note that the indicated yields on municipal bond funds can be misleading. They often appear lower than those of comparable maturity Treasury or corporate bonds.
The more appropriate measure to evaluate municipal bonds is the “taxable equivalent yield.” This metric indicates the interest rate a taxable bond would need to provide an equivalent after-tax return as a tax-exempt municipal bond, considering the investor’s tax bracket.
This calculation helps investors accurately assess the real benefit of including tax-exempt municipal bonds in their portfolios.
Here are seven of the best municipal bond funds to buy today:
| Fund | Expense ratio |
| Fidelity Municipal Bond Index Fund (ticker: FMBIX) | 0.07% |
| 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% |
| iShares New York Muni Bond ETF (NYF) | 0.25% |
| iShares California Muni Bond ETF (CMF) | 0.08% |
| iShares National Muni Bond ETF (MUB) | 0.05% |
Fidelity Municipal Bond Index Fund (FMBIX)
“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.” For example, the Bloomberg Municipal Bond Index tracked by FMBIX currently has over 1,700 holdings.
The municipal bonds held in FMBIX include both revenue bonds and general obligation bonds issued by 49 states, with California and New York issuers holding a 20.5% and 14.2% portfolio weight, respectively. Virtually all of FMBIX’s issuers are rated investment-grade (BBB and above), with 52% rated AA. Investors can expect a low 0.07% expense ratio and no minimum required investment amount.
FMBIX offers a 30-day yield of 3.4%.
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.”
To achieve this degree of diversification, VTEB tracks the S&P National AMT-Free Municipal Bond Index. To ensure liquidity, VTEB uses a sampling methodology to directly replicate at least 80% of the index’s composition. Investors can currently expect over 10,400 bonds exempt from federal income taxes and the federal alternative minimum tax (AMT) paying a 3.6% average yield to maturity.
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, VTEB has an intermediate average duration of 6.5 years. All else being equal, a 100-basis-point increase in interest rates will cause VTEB to lose 6.5% in net asset value, or NAV.
Therefore, investors wary of interest rate risk may wish to opt for VTEB’s short-duration cousin, VTES. This fund tracks the S&P 0-7 Year National AMT-Free Municipal Bond Index, which holds over 2,100 municipal bonds averaging a 2.4-year duration, and currently pays a 3.2% yield to maturity. VTES carries a 0.07% expense ratio, making it slightly more expensive than VTEB.
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.” Certain municipal entities may be at a higher risk of default, meaning that the issuers could lack the funds to pay the agreed-upon interest on their bonds or the principal back at maturity.
Still, the inherent diversification present in a fund provides even high-yield municipal bond investors with greater protection. For instance, VWAHX’s portfolio holds over 3,200 issuers, 80% of which are rated investment grade, while 20% is reserved for non-investment-grade-rated municipal bonds. The result is a higher yield to maturity of 4%. VWAHX charges a 0.17% expense ratio and requires a $3,000 investment.
iShares New York Muni Bond ETF (NYF)
“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 residing in New York can opt for NYF over picking individual issuers. This ETF tracks the ICE AMT-Free New York Plus Municipal Index, which as its name suggests also holds bonds exempt from the federal AMT. Currently, investors can expect a 3.6% average yield to maturity and, like most bond ETFs, monthly distributions. NYF charges a 0.25% expense ratio.
iShares California Muni Bond ETF (CMF)
Similarly, high-income-bracket investors residing in California can use CMF to avoid federal taxes and the AMT. This ETF tracks the ICE AMT-Free California Municipal Index, which currently holds over 1,100 bonds issued by agencies like the University of California, California State University, the California Educational Facilities Authority and the California State Public Works Board.
Overall, these entities have robust credit ratings, with 76.8% of them rated AA and 15% assigned an AAA rating, which implies a low probability of default. The ETF is currently paying a 3.4% average yield to maturity and has an intermediate duration of 6.2 years. It is also significantly cheaper than NYF, charging a far lower 0.08% expense ratio.
iShares National Muni Bond ETF (MUB)
On the other hand, investors looking for the broadest possible diversification for their municipal bond fund may wish to consider MUB. This ETF tracks the ICE AMT-Free U.S. National Municipal Index, giving it breadth across 5,600 bonds issued by multiple states. However, municipal bonds from California and New York are still assigned high weights at 20.1% and 21.7%, respectively.
As expected, MUB has an overall excellent credit rating, with 13.3% of its portfolio rated A, 58% rated AA and 24.6% rated AAA. Many of its issuers are classified as either state or local tax-backed, with some issued from public utilities, transportation or educational institutions. MUB currently pays a 3.6% yield to maturity and charges the same 0.05% expense ratio as VTEB.
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 04/25/24: This story was published at an earlier date and has been updated with new information.
