One common criticism among investors and financial advisors regarding aggregate bond funds is their relative lack of tax efficiency. This inefficiency arises because these funds, as the name implies, encompass a broad spectrum of bond types. Typically, this includes Treasurys, mortgage-backed securities and investment-grade corporate bonds.
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The interest income from each of these carries different tax implications: Treasury bonds offer some tax relief as they are exempt from state and local taxes, but corporate bonds don’t share this advantage. When the returns from these various bonds are pooled into the fund’s distributions, the overall tax efficiency diminishes.
Consider the Vanguard Total Bond Market ETF (ticker: BND), a popular bond exchange-traded fund (ETF) that tracks more than 11,000 bond issues represented by the Bloomberg U.S. Aggregate Float Adjusted Index. Vanguard’s data show that after accounting for taxes on the ETF’s distributions, the annualized 10-year total returns for BND plummet from 1.8% to just 0.7% — a reduction of more than half.
Thus, if you are tax-conscious and have maxed out the tax-sheltered spaces in vehicles like a Roth IRA or 401(k), yet still wish to invest in bonds, funds holding municipal bonds could be a strategic alternative. “These are debt instruments issued by states, cities, counties and other governmental entities to finance public projects like roads, bridges and schools,” explains Nathan Will, principal and head of municipal credit research at Vanguard.
Despite their tax efficiency, municipal bonds still suffer from some of the same drawbacks as individual bonds when it comes to retail accessibility. Given their over-the-counter traded status and opaque pricing, investing in individual issues can be difficult.
“For the most part, trying to hand pick individual municipal bonds can be time consuming and create additional risk,” says Brandon M. Clark, a certified financial planner at The Clark Group Asset Management. “In contrast, a municipal bond fund creates more diversification and lowers the chances of default risk by investing in hundreds or even thousands of high-quality bonds.”
Will agrees with Clark on the risk management benefits of municipal bonds funds. “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,” he explains.
Here are seven of the best municipal bond mutual funds and ETFs to buy today:
| Fund | 30-day SEC yield | Expense ratio |
| Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX) | 3.2% | 0.09% |
| Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX) | 3.9% | 0.23% |
| Vanguard Tax-Exempt Bond ETF (VTEB) | 3.3% | 0.05% |
| Vanguard California Long-Term Tax-Exempt Fund Admiral Shares (VCLAX) | 3.4% | 0.09% |
| iShares National Muni Bond ETF (MUB) | 3.2% | 0.05% |
| Fidelity Municipal Bond Index Fund (FMBIX) | 3.2% | 0.07% |
| Invesco National AMT-Free Municipal Bond ETF (PZA) | 3.5% | 0.28% |
Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX)
“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.” For example, the 10,000-plus municipal bonds tracked by the S&P National AMT-Free Municipal Bond Index are largely rated “AA,” with a few rated even higher at “AAA.”
Investors can gain exposure to this municipal bond benchmark via VTEAX, which uses a passive sampling technique to construct a portfolio similar in the aggregate. Currently, VTEAX has a duration of 6.5 years, which implies moderate interest rate sensitivity, and a 30-day SEC yield of 3.2%. The fund charges a 0.09% expense ratio, or $9 annually for a $10,000 investment.
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 will hold bonds issued by local government entities with lower-than-investment-grade credit ratings, which increases default risk but also enhances yield.
However, this risk can be mitigated by pooling many high-yield municipal bonds into a diversified fund, and that’s exactly what VWAHX does. This actively managed fund is able to invest up to 20% of its holdings in non-investment-grade municipal bonds. By doing so, VWAHX is able to boost its 30-day yield a bit higher, to 3.9%. The fund charges a 0.23% expense ratio and has a $3,000 minimum investment.
Vanguard Tax-Exempt Bond ETF (VTEB)
“For certain high-income and retired clients, we’ve been adding VTEB into their taxable brokerage accounts for a portion of their fixed-income allocation, especially for clients that live in states like Nevada or Texas with no state income tax to worry about,” Clark says. This ETF offers the same exposures as VTEAX does, but with some additional advantages that some investors may find appealing.
As an ETF, shares of VTEB trade throughout the day on an exchange. In contrast, VTEAX can only be purchased once per day at market close after Vanguard calculates its net asset value (NAV). In addition, VTEB is slightly cheaper with a 0.05% expense ratio versus 0.09% for VTEAX. Finally, VTEB’s minimum required investment is simply the price of one share, whereas VTEAX requires at least $3,000.
Vanguard California Long-Term Tax-Exempt Fund Admiral Shares (VCLAX)
“For our clients in California, we have been adding VCLAX,” Clark says. “With income tax rates for California being so high, this can really add a lot of value by avoiding income tax entirely, both federally and on the state level.” Despite the use of active management, VCLAX is still very affordable with a 0.09% expense ratio, comparable to passively managed index-based funds like VTEAX.
“Even with lower yields than corporate bonds, the after-tax impact of a California municipal bond fund in some cases can be more advantageous by generating greater after-tax returns,” Clark explains. Thus, it’s important for investors not to take VCLAX’s 3.4% 30-day SEC yield at face value. Instead, consider using an online calculator to figure out the fund’s tax-equivalent yield based on your income bracket.
iShares National Muni Bond ETF (MUB)
“Some municipal bond funds focus on specific states, offering additional advantages for residents of heavily taxed areas such as California, New York or Illinois,” says Michael Ashley Schulman, chief investment officer at Running Point Capital Advisors. “However, this strategy limits the diversification benefits you’d get from investing in a nationwide municipal bond fund.” For this role, consider MUB.
This ETF tracks the ICE AMT-Free U.S. National Municipal Index, which holds 5,800 bonds paying a 3.2% 30-day yield at a duration of 6.3 years. Bonds in this ETF hail from 47 different states, reducing concentration risk. “Fiscal irresponsibility and/or regional natural disasters such as hurricanes, tornadoes, floods and earthquakes are major state-specific risks,” Schulman notes.
Fidelity Municipal Bond Index Fund (FMBIX)
“Some of the better bond market mutual funds have low expense ratios, no front- or back-end load costs, no 12b-1 marketing fees, performance that closely hugs their benchmark (i.e., low tracking error), and steady or consistent inflows over time,” Schulman explains. One popular municipal bond mutual fund that hits all these marks is FMBIX, which Fidelity has offered since July 2019.
FMBIX is highly accessible and affordable with no minimum required investment amount, no transaction fees on Fidelity’s brokerage platform and a low 0.07% expense ratio. It tracks the Bloomberg Municipal Bond Index using a sampling technique, giving it exposure to more than 1,700 revenue and general obligations municipal bonds from across the U.S. FMBIX pays distributions on a monthly basis.
Invesco National AMT-Free Municipal Bond ETF (PZA)
For investors in high income brackets, it might be prudent to consider funds that are exempt from the alternative minimum tax (AMT). This is a supplemental income tax imposed by the federal government to ensure that those benefiting from certain deductions will pay at least a minimum amount of tax. For this role, an AMT-free municipal bond fund like PZA might be a suitable holding.
This ETF invests at least 80% of its assets in securities represented by its benchmark, the ICE BofAML National Long-Term Core Plus Municipal Securities Index. Bonds in this ETF must have at least 15 years remaining until maturity, giving the fund higher interest rate sensitivity with a 13.4-year modified duration. PZA has a 3.5% 30-day yield and charges a 0.28% expense ratio.
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7 of the Best Tax-Free Municipal Bond Funds originally appeared on usnews.com
Update 10/22/24: This story was previously published at an earlier date and has been updated with new information.
