Although stocks often take the spotlight in the investment world, municipal bonds can also play a crucial role in a diversified portfolio, offering attractive tax advantages. Municipal bonds, also known as munis, are issued by state and local governments to finance various government projects. Unlike most bonds, they are typically exempt from federal income tax, making them a popular choice for investors in higher tax brackets.
Here’s everything you need to know about municipal bonds and some top funds to consider for your taxable portfolio.
Understanding Municipal Bonds and How They Operate
Municipal bonds are issued by state and local governments to raise funds for public projects such as schools and infrastructure. General obligation bonds are used for projects that are not expected to generate revenue, while revenue bonds are repaid with revenue from specific projects, such as toll roads or entertainment venues.
Although municipal bonds may not sound like the most thrilling investment, they often come with the benefit of tax exemption. In many cases, investors may not owe state or local taxes either. Due to this tax advantage, a lower yield on a municipal bond may actually be more appealing than a higher-yielding taxable bond once you factor in the tax savings.
Here’s how it works: Suppose you are a high earner with a federal income tax rate of 37 percent and a state tax rate of 7 percent. You are considering a municipal bond with a yield of 3 percent and a taxable bond with a yield of 4 percent.
Tax-equivalent yield = Interest rate / (1 - tax rate)
You will find that the municipal bond has a tax-equivalent yield of almost 4.8 percent based on federal tax savings alone, and the tax-equivalent yield increases to 5.4 percent when you consider the additional state tax savings, both of which surpass the 4 percent yield on the taxable bond.
Investors in higher tax brackets benefit the most from the tax advantages of municipal bonds, but even if you are in a lower tax bracket, munis may still be a suitable addition to your portfolio. Generally, municipal bonds come with a low risk of default and exhibit less volatility compared to riskier corporate bonds or stocks.
While you have the option to invest in individual municipal bonds, investing in a municipal bond fund can be more convenient. By investing in a fund, you can avoid the need to research individual investments and enjoy the benefits of holding a diversified portfolio of municipal bonds. Here are some top funds you may want to consider.
Top Municipal Bond Funds
Data as of July 17, 2024.
Vanguard Tax-Exempt Bond ETF (VTEB)
The Vanguard Tax-Exempt Bond ETF is an index fund that aims to track the performance of a benchmark measuring the investment-grade U.S. municipal bond market. At least 80 percent of the fund’s assets are invested in securities whose income is exempt from federal income tax.
- 5-year annualized return: 1.2 percent
- Yield: 3.63 percent
- Expense ratio: 0.05 percent
- Total assets: $33.3 billion
Fidelity Tax-Free Bond Fund (FTABX)
The Fidelity Tax-Free Bond Fund aims to provide a high current yield that is exempt from federal income tax. The fund invests at least 80 percent of its assets in investment-grade securities whose interest is exempt from federal income tax. The fund may engage in transactions that have a leveraging effect on the fund, which magnifies gains and losses.
- 5-year annualized return: 1.4 percent
- Yield: 3.60 percent
- Expense ratio: 0.25 percent
- Total assets: $3.4 billion
T. Rowe Price Tax-Free High Yield Fund (PRFHX)
The T. Rowe Price Tax-Free High Yield Fund aims to achieve a high level of income that is exempt from federal income tax by investing in long-term municipal securities with a low to upper-medium investment grade. The fund invests a significant portion of its assets in municipal “junk” bonds and may purchase defaulted bonds as long as they do not exceed 10 percent of assets.
- 5-year annualized return: 1.7 percent
- Yield: 3.72 percent
- Expense ratio: 0.67 percent
- Total assets: $3.4 billion
BlackRock Allocation Target Shares: Series E Fund (BATEX)
This BlackRock fund aims to provide investors with higher federal tax-free income than other muni bond funds that invest in investment-grade securities by purchasing both investment-grade and non-investment-grade municipal bonds. Approximately half of the fund is invested in municipal “junk” bonds, and up to 10 percent of assets can be allocated to distressed securities.
- 5-year annualized return: 3.2 percent
- Yield: 3.58 percent
- Expense ratio: 0.12 percent
- Total assets: $447.5 million
Delaware National High-Yield Municipal Bond Fund Institutional Class (DVHIX)
The Delaware National High-Yield Municipal Bond Fund invests in medium and lower-grade municipal bonds to generate a high level of current income that is exempt from federal income tax. The fund currently holds approximately 14 percent of its assets in Puerto Rican debt, while another 12 percent of the fund’s investments are from California.
- 5-year annualized return: 2.93 percent
- Yield: 4.70 percent
- Expense ratio: 0.60 percent
- Total assets: $3.2 billion
Vanguard High-Yield Tax-Exempt Fund Admiral Shares (VWALX)
The Vanguard High-Yield Tax-Exempt Fund invests in long-term municipal bonds with medium to high credit quality and aims to generate high and sustainable current income exempt from federal income tax. The portfolio has an average maturity of 10 to 25 years and focuses on sectors representing relative value.
- 5-year annualized return: 1.96 percent
- Yield: 4.14 percent
- Expense ratio: 0.09 percent
- Total assets: $15.7 billion
Key Takeaways
While municipal bonds may not offer returns as high as other investments like stocks, they can provide valuable tax benefits to your portfolio, especially if you are in a high-income tax bracket. Due to these tax advantages, it is advisable to hold municipal bond funds in taxable accounts only, rather than in retirement accounts such as 401(k)s and IRAs, which already come with tax benefits.
Editorial Disclaimer: All investors are encouraged to conduct their own independent research on investment strategies before making any investment decisions. Additionally, investors should be aware that past performance of investment products is not a guarantee of future price appreciation.