As the saying goes, “nothing is certain in life but death and taxes,” and this adage seems especially true for bond investors. Typically, investing in bonds outside of tax-advantaged accounts like a Roth IRA or 401(k) means dealing with the headache of a higher tax bill.
Most bond funds, when held in a taxable brokerage account, are tax-inefficient, with income taxed at ordinary federal and state rates in the year it’s earned. While funds holding U.S. Treasury bonds exclusively may offer some relief by being exempt from state taxes, they’re still subject to federal taxes.
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However, there is one exception particularly beneficial for high-income-bracket investors: municipal bonds. These bonds are generally exempt from federal taxes and, in many cases, state and local taxes as well, especially if the bonds are issued by your state of residence.
“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.
As a type of government bond, most municipal bonds have credit ratings that put them somewhere in between Treasurys and investment-grade corporate bonds in terms of 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.”
When pooled in a fund, municipal bonds further gain the benefits of professional management, including monthly distributions and other structural advantages.
“There are several advantages to using a fund structure for investing in municipal bonds,” says Stuart Gillin, assistant vice president and 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 mutual funds and ETFs to buy today:
| Fund | Expense Ratio |
| Vanguard Tax-Exempt Bond ETF (ticker: VTEB) | 0.05% |
| Fidelity Municipal Bond Index Fund (FMBIX) | 0.07% |
| Schwab Tax-Free Bond Fund (SWNTX) | 0.38% |
| 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% |
| BlackRock Short Maturity Municipal Bond ETF (MEAR) | 0.25% |
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.” An example of this is VTEB, which has more than 10,000 holdings.
Like many Vanguard funds, VTEB is passively managed. Through a sampling technique, the fund attempts to track the returns and risk of the Standard & Poor’s National AMT-Free Municipal Bond Index. The holdings in VTEB are exempt from both federal income taxes and the alternative minimum tax. Right now, investors can expect a 3.3% 30-day SEC yield and a low 0.05% expense ratio.
Fidelity Municipal Bond Index Fund (FMBIX)
Investors seeking a tax-efficient bond fund on Fidelity’s platform can use FMBIX. For a 0.07% expense ratio, this fund tracks the Bloomberg Municipal Bond Index via a sampling technique. Like many Fidelity mutual funds, FMBIX does not have a minimum required investment nor does it charge a transaction fee. Right now, the fund is paying a 3.5% 30-day SEC yield with monthly distributions.
The use of the Bloomberg Municipal Bond Index as its benchmark provides FMBIX with high diversification. Currently, this fund features more than 1,800 holdings, mainly from the states of California, New York, Texas, Florida and Illinois, with a majority holding “A” to “AAA” credit ratings, the latter of which is the top-end of the investment-grade rated spectrum. It also has fairly low turnover for a bond fund, at 15%.
Schwab Tax-Free Bond Fund (SWNTX)
Most of the large fund managers will offer one or more municipal bond mutual funds, and Charles Schwab Corp. (SCHW) is no exception. The firm offers SWNTX, which unlike the previous funds is actively managed. That is, it does not track an index. Instead, SWNTX’s managers rely on their own research and skills to invest in municipal bonds exempt from federal income tax and AMT.
Like many Schwab mutual funds, SWNTX has no minimum investment requirement or sales loads. However, the use of active management as opposed to passive indexing makes it pricier, with a 0.38% expense ratio and very high 132% annual portfolio turnover. Currently, investors can expect a 3.4% 30-day SEC yield, which like most bond funds is paid on a monthly basis.
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Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX)
Despite being government entities, not all municipalities have investment-grade credit ratings. While the majority are rated at least “BBB,” with many being “A” or higher, some might be distressed. To compensate for their poorer financials and the greater risk of default, these municipalities will issue bonds paying higher yields. Although very rare, municipalities can default on their obligations.
“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.” Case in point, VWAHX is able to pay a tax-efficient 4% 30-day SEC yield by reserving 20% of its portfolio for non-investment-grade municipal bonds. The fund charges 0.17%.
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.”
With an income tax rate of anywhere from 1% to 12.3%, California investors, especially those in a high-income bracket, may find a state-specific municipal bond ETF like CMF appealing. The issuers in this ETF include the University of California, the California State Public Works Board and the Los Angeles Department of Water and Power. CMF pays a 3% 30-day SEC yield and charges a 0.08% expense ratio.
iShares New York Muni Bond ETF (NYF)
High-income-bracket investors in New York are taxed even more than their California counterparts, with nine income tax rates going as high as 10.9%. To alleviate this, New York investors can buy NYF, which is their state’s equivalent to CMF. This ETF tracks the CE AMT-Free New York Plus Municipal Index for a 0.25% expense ratio and currently pays a 3.1% 30-day SEC yield.
As its index benchmark suggests, the holdings in NYF are all issued by New York-domiciled state and municipal entities with a strong focus on infrastructure-oriented agencies. Notable issuers include the Triborough Bridge & Tunnel Authority, the Long Island Power Authority, the Port Authority of New York and New Jersey, and even the Metropolitan Transportation Authority.
BlackRock Short Maturity Municipal Bond ETF (MEAR)
For maximum stability when investing in municipal bonds, consider a short-maturity ETF like MEAR. This ETF is designed to be a step up from holding cash. By tracking the Bloomberg Municipal Bond: 1 Year (1-2) Index, it aims to deliver a combination of low interest rate and credit risk, while providing stronger tax efficiency. Currently, this ETF is paying a 3.3% 30-day SEC yield at a 0.25% expense ratio.
Despite carrying low risk, investors should not use MEAR as a total replacement for a municipal money market fund. Unlike the latter, the net asset value (NAV) of MEAR is not fixed at a steady level. Although less volatile in general, shares of MEAR can fluctuate up and down in a way that money market funds will not, putting your principal investment at greater risk.
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 08/30/24: This story was previously published at an earlier date and has been updated with new information.
