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I always thought that municipal bond funds were only for investors in upper income tax brackets. The lower interest rates that municipal bonds pay are offset by the fact that interest from these funds is tax exempt. Thus only high earners benefit.
My recent research shows that this isn’t necessarily the case. In fact, municipal or tax-exempt bond funds from Fidelity, Schwab, and Vanguard have outperformed comparable taxable bond funds of the same credit quality and maturity.
Its time to consider including municipal bond funds in your brokerage account regardless of your income tax bracket.
What are Municipal Bonds?
Municipal bonds are debt securities issued by a state, municipality, county, or special purpose district (public schools, airports, etc.).Thy are used to finance capital expenditures. Municipal bond interest is exempt from federal taxes. It also is exempt from most state and local taxes if you live in the state in which the bond is issued. For example, the Washington Metropolitan Area Transit Authority issues revenue bonds secured by a pledge of fares that Metro riders pay. By making the interest tax free, Congress lowered the borrowing costs for municipalities and states.
You can invest in individual munis. I don’t recommend that you do so unless you have a lot of money to invest.
You also can invest in municipal bond funds which aggregate bonds from various issuers. Bond funds come in three main varieties that vary based on the average maturity date of the fund’s bonds. You can generally invest in short-term (1-3 years), intermediate-term (3 to 6 years), and long-term (greater than 7 to 10 years) bond funds.
Bond funds also have varying credit quality. Credit quality measures the likelihood that the bond issuer will pay the monthly interest and pay off the bonds when they mature. Bond investors should always look for highly rated bond funds. If you want to take on more risk, do so in stocks where the return is likely to be much richer. Don’t do it in bonds.
Who Uses Municipal Bond Funds?
The main reason that investors invest in municipal bond funds is that the income they produce is generally not taxable. Municipal bonds, therefore, generally don’t pay as high a coupon rate compared to comparable corporate bonds.
Let’s say your effective tax rate including federal, state and local income taxes is 25 percent. If you buy a municipal bond that yields 6 percent, then it would be the equivalent of a taxable yield of 8 percent. Put another way, you would be earning an extra 2 percent because of the tax benefits.
Municipal Bond Funds in Your Brokerage Account
Often folks invest in bond funds because they want a more conservatively allocated brokerage account. They may need the money sooner and don’t want to take on much risk with a lot of stocks. Thus, they use an asset allocation in their brokerage account that is, say 60% stocks and 40% bonds. Bond funds can be used to fill this allocation.
It is best to avoid bond funds with a long-term maturity dates in today’s low-interest rate environment. You will be stuck with low yielding bonds when interest rates rise. Rather, look to intermediate and short-term bond funds.
Low-cost brokerages offer high quality bonds funds in both short and intermediate term flavors – both taxable ones and tax-exempt (municipal) ones. Fidelity, Schwab, and Vanguard offer both municipal and taxable intermediate-term bond funds.
I compared the total return of the intermediate taxable and tax-exempt fund offerings from each brokerage. I used a dollar cost averaging approach. The same amount was invested each month in each fund for the duration of the period. I tested five different periods ending on February 29, 2016.
- 62 months starting January 1, 2011
- 50 months starting January 1, 2012
- 38 months starting January 1, 2013
- 26 months starting January 1, 2014
- 14 months starting January 1, 2015
Dividends and distributions were reinvested. Dollar-cost averaging with automatic reinvestment is used by most investors.
The ending value of the intermediate-term tax-exempt bond funds from each brokerage beat their taxable counterparts. They did so in each of the five periods. Meaning that it wasn’t just one “good” year that pushed the tax-exempt funds ahead of their taxable counterparts.
And this result was BEFORE considering taxes. The performance gap only widens when taxes are considered. Indeed, all of the reinvested interest payments from the tax-exempt funds were tax free. The results are as follows.
- Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) outperformed Vanguard Intermediate-Term Bond Index Fund (VBILX)
- Schwab Tax-Free Bond Fund (SWNTX) outperformed Schwab Intermediate-Term Bond Fund (SWIIX)
- Fidelity Intermediate Municipal Income (FLTMX) outperformed Fidelity Intermediate Bond (FTHRX)
Take Away from these Results
Of course the past cannot predict the future. But consider intermediate municipal or tax-exempt bond funds rather than taxable ones in your brokerage account. The return is likely to be better and you won’t be raising your tax burden, regardless of your income tax bracket.
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