Tax-exempt bond funds offer handsome yields these days. This survey takes you quickly to the 40 Best Buys.
Good news for savers in fairly high tax brackets: Yields on municipal bonds are good, comfortably ahead of what you can clear from Treasury bonds.
Bad news: This is a treacherous field. It is easy to be gouged buying either individual bonds or high-fee funds.
Municipal bonds are worth considering for any fixed-income money you have in taxable accounts. For tax-sheltered accounts like IRAs, munis are inappropriate; there, use this survey of taxable bonds and bond funds.
For taxable accounts, munis are a buy. Says Patrick Haskell, who oversees a $182 billion pile of them at BlackRock: “We haven’t had the opportunity to invest at these levels of real and nominal yields since the financial crisis.”
The numbers he has in mind: For bonds due in ten years, tax-exempt yields are 80% of U.S. Treasury yields, not bad for anyone destined to pay a tax of 20% or more on interest. At the 30-year mark the percentage is close to 100%. There is a catch with the long munis, having to do with the risk they will be called in early (see rule #3 below), but they remain very attractive even after allowance for this risk.
What about that talk of making interest on all state and municipal debt federally taxable (for the first time)? Haskell: “Am I threatened? No.” If this happens, he says, existing bonds will be grandfathered. And if the wise people in Congress decree that henceforth states and cities can issue only taxable debt, his job is not over. The same sewers and school buildings would have to be financed, and the clientele for the bonds would expand to include investors who don’t touch them now, like foreigners and endowment funds.
Are you interested in collecting 4% interest federally tax-free? There are too many choices. Fidelity has on its sale counter 138,000 individual tax-exempt bonds. You could get a fund, but even so there is a selection process. YCharts counts 3,700, including all the share classes.
This fund survey aims to make the investment easy. On individual bonds our advice is simple: Don’t buy them. As for funds: We narrow the roster of those worth looking at to 40.
First, exchange-traded funds, the newer kind of fund that until recently had scarcely anything to offer to muni investors. Here’s a list of 24 of them. These ETFs have annual expense burdens no higher than 0.18%. They each average a daily trading volume of at least $1 million, meaning that you can probably get in and out without getting eaten alive by the bid/ask spread:
The older style of fund is a mutual fund. No-load mutuals impose no trading costs but tend to have higher expense ratios. Alas, the subset of municipal-bond mutuals with bargain expense ratios is tiny. All of the funds shown here come from Vanguard. Note: Where Vanguard has both a small-stakes share class starting at $3,000 and a large-stakes version for buyers putting in $50,000, the table displays only the latter.
Here are some rules to live by when investing in municipal bonds.
1. Prefer Funds
There are two problems with individual tax-exempt bonds. One is that they are hard to research. The IOU you thought was backed by a city or state may in fact be backed only by the revenue from a decrepit nursing home. Do you really want to spend your free time reading fine print?
The other matter is that muni bonds are hard to trade. You were perhaps planning to hold until redemption, but things happen. You might need to raise cash. Or you might want to take a tax loss during a spike in interest rates.
To get an idea of what befalls small investors trying to sell, take a look at the bond offerings on your brokerage platform. How many are listed as available for sale but with no quote on the bid side? A blank spot for the bid is an indication that, if you need to unload in a hurry, you will get hosed by a middleman.
Cashing out a muni fund, in contrast, is easy. To swap for a tax loss, find a substitute fund that isn’t exactly the same. Example: Vanguard Tax-Exempt Bond Index behaves much like iShares National Muni Bond but is sufficiently different that the IRS can’t call the swap a wash. After 31 days you can go back where you were, if you want to.
2. Watch The Fees
It’s easy to find a well-managed fund costing an annual 0.1% or less. It might make sense to pay a little more to get what you want in duration (rate risk) or timing (as with those target-date funds). But not a lot more.
Don’t be led astray by the double-tax-free allure of a fund holding only home-state bonds. State income tax rates are usually less than 10%, and muni yields about 4%. There is, that is, not a lot of state tax to be avoided.
Kentucky’s flat tax rate is 4%, so the most that a rational Kentucky resident would pay in incremental cost to avoid local tax is 4% of 4%, or 0.16%. How curious that holders of the class C shares of the Nuveen Kentucky Municipal Bond fund pay 1.93% in annual fees, 64 times what they’d pay to hold a muni bond index ETF from Vanguard. Nuveen, a TIAA subsidiary, has another 24 single-state funds on offer for the mathematically challenged.
Simple rule of thumb: If Vanguard has a single-state fund for your state, buy it. If Vanguard doesn’t, buy a national fund.
3. Beware Calls
The customary practice for a state or city borrowing money is to offer a fairly high coupon on a bond due in 30 years, while reserving the right to call the bond in early beginning in 10 years. For the bond issuer this arrangement is rather nice. For the bond buyer it’s awful. It turns the investment into a heads-you-break-even, tails-you-lose proposition.
If interest rates go down, the issuer calls in the bond. That is, the buyer has the good coupon for only 10 years. If rates go up, the issuer stands pat, leaving the buyer stuck for another 20 years at a below-market yield. This unwanted 20-year bond will trade at a discount.
The lopsided set of possible outcomes makes quite a contrast to the bet on a noncallable 30-year Treasury bond. Long Treasuries are risky, but the risk is symmetric. They fall in value if interest rates climb, but they are just as likely to rise in value as interest rates go down.
Muni owners should be cognizant that they have made asymmetric bets on interest rates. In other words: Muni bond yields overstate expected returns.
By how much? To properly answer that question you need to assess, using each bond’s coupon, call date and maturity date, the effect of 10,000 possible paths that interest rates might take between now and 2055, and assign a probability to each path.
Such a calculation would be a bit impractical. But you can get a sense of how harmful call provisions are by observing how much compensation investors demand for putting up with them. For AAA-rated munis the yield curve (2 years out versus 30 years) is 50 basis points, or half a percentage point, steeper than the yield curve for Treasuries. A portfolio of long-dated callable bonds has embedded in it some appreciable fraction of that 50 basis points as an expected loss from rate volatility.
The following table of net yields aims to deliver rough justice to the situation. It debits the officially reported yields on long-term muni funds for an estimate of call damage. Taxes are allowed for, as well, at different income levels, in two high-tax states.
Conclusion: For people in moderately high or very high tax brackets, municipal debt is usually more rewarding than Treasury debt. It’s just not quite as good a deal as bond salesmen would have you believe.
4. Know Your Bracket
The 22% federal bracket, which starts at $96,950 of taxable income on a joint return, is where muni bond interest begins to beat out Treasury bond interest. In the next bracket up, 24%, most couples are also paying a 3.8% investment tax, for a combined federal rate of 27.8%.
What about the alternative minimum tax? This affliction largely evaporated with the passage of the 2017 tax law. If the problem reappears, which would happen if Congress fails to extend that law, AMT is still likely to matter only in money-market muni funds and in high-yield muni funds. In short, it’s not worth paying extra fees to get a fund labeled “AMT-free.”
State rates, which never apply to U.S. Treasury interest and usually but not always apply to interest on out-of-state municipal bonds, range from 0% to 14.8%. Two states with stiff taxes, New York and California, are home to low-fee double-tax-free funds. New York bonds have pretty good yields. California yields, however, are not terrific and investors there are often better off buying a national muni fund.
A peculiarity of the tax code gives fund investors an advantage over bond investors. Say a bond comes out at par and sinks to 90 cents on the dollar as rates rise. If you buy at 90 and redeem at 100, the 10-point gain is taxed as ordinary income (which is totally unfair).
Now let’s say a fund buys bonds at 100 and, as interest rates rise, the bonds fall in price to 90 and the fund shares fall in price from $100 to $90. You buy the fund at $90 and see its shares gradually recover as its bonds mature and get cashed out at par. You now sell the fund at $100. Your $10 gain is taxed at the lower capital gain rate.
DID SOMEBODY SAY “DEFAULT”?
There are, broadly speaking, two kinds of municipal debt. General obligation bonds are backed by a government’s taxing power, which usually makes them pretty safe. Revenue bonds, in contrast, are repaid from the income from some project, which might be as secure as a popular toll road or as sketchy as a parking garage in the Bronx.
Bad things happen. Fifty years ago New York City defaulted on its debt, repaying investors who were promised cash on a certain date with more IOUs. At least those pieces of paper were eventually made good; the city is now considered a sound credit. More recently, Detroit and Puerto Rico went bankrupt, costing bondholders serious money.
Most municipal bond funds, except those labeled “high yield,” stick to higher-rated paper. The iShares National Muni Bond ETF, for example, has 82% of assets in bonds rated AAA or AA. But it has entrusted a bit of your money to Chicago, which always seems to be one teachers union cave-in away from a financial collapse.
Seekers of safety sometimes pass up tax-free bonds in favor of taxable ones from the Treasury. The U.S. government is usually taken to be free of credit risk. Does it deserve to be? What if somebody there decides to amuse himself by declaring a moratorium on debt repayments?
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