What it means
Municipal bonds are loans made to local governments, which use the money for schools, roads, water systems and similar projects. Buying individual bonds can be costly and time consuming, because each one has a minimum size and needs credit research.
A fund spreads the investor's money across many issuers and lets professionals do the research. The key attraction is tax treatment.
Because the interest on most municipal bonds is exempt from federal income tax, the investor keeps more of each dollar of income than with a taxable bond paying the same rate. The benefit grows with the investor's tax rate, so these funds appeal mostly to people in higher brackets.
To compare a municipal fund with a taxable alternative, investors calculate the tax-equivalent yield, which is the taxable yield needed to match the after-tax income. Funds that hold bonds from a single state may also be exempt from that state's tax for its residents.
Some interest can be subject to the alternative minimum tax, and gains from selling bonds or fund shares are taxable. There are risks.
Bond prices fall when interest rates rise, so a fund with long-dated bonds can lose value, and a few issuers do default, although defaults on higher-quality municipal bonds have historically been uncommon. Funds also charge an expense ratio, which is an annual fee as a percentage of assets, and it directly reduces the income received.
For finance professionals, the key is to judge a fund by its after-tax yield, the quality of its holdings and its cost. A fund holding only the highest-rated bonds will yield less than one reaching for extra income in weaker credits.
Matching the fund's average maturity to the investor's time horizon is also important. Choosing between funds comes down to a few practical checks.
Look at the average credit quality of the holdings, the average maturity, the expense ratio and whether the fund concentrates on one state or spreads across many. A fund concentrated in one state can pay higher tax-free income to its residents but is more exposed to that state's economy.
In practice
Real-world examples.
Example
A surgeon in a high tax bracket has $500,000 to invest for income. She chooses a municipal bond fund because the tax-free interest leaves her with more after tax than a corporate bond fund of similar risk. She checks that the fund holds mostly high-quality bonds and keeps her emergency savings in cash.
Example
A retired couple in a low tax bracket compares a municipal fund yielding 3.0% with a taxable fund yielding 4.5%. After working out the tax-equivalent yield, they see the taxable fund is better for them. They decide the simplicity of the taxable fund is worth the slightly higher tax bill.
Example
A business owner holds a fund of bonds issued in her own state. She pays no federal tax on the interest and, as a resident, no state tax either, which improves her after-tax return. She checks that the fund provides a yearly statement showing the share of income that qualifies for state exemption.
Formula
Calculation
Tax-equivalent yield = Municipal yield / (1 - Tax rate)
Suppose a municipal bond fund yields 3.0% and the investor's marginal tax rate is 40%. The tax-equivalent yield = 3.0% / (1 - 0.40) = 3.0% / 0.60 = 5.0%. Check: on a $100,000 investment, a taxable bond paying 5.0% earns $5,000, which after 40% tax leaves 5,000 x 0.60 = $3,000. The municipal fund earns 3.0% of $100,000 = $3,000 tax free, so both give the same result.Case study
Seen in the real world.
Brightwater Advisors is an illustrative, fictional firm helping a client, a software executive, invest $400,000 of surplus cash. His marginal tax rate is 37% on federal income, and he wants steady income with low risk.
The adviser compares a municipal bond fund yielding 3.2% with a taxable bond fund yielding 4.6%. The tax-equivalent yield of the municipal fund is 3.2% / (1 - 0.37) = 3.2% / 0.63 = about 5.08%, which is higher than 4.6%.
The client invests in the municipal fund and earns about 400,000 x 0.032 = $12,800 a year free of federal tax. The illustrative lesson is that the right choice depends on the investor's tax rate, and the same fund could be a poor choice for someone in a lower bracket.
Watch out
Common mistakes.
- Comparing the municipal yield directly with a taxable yield, without adjusting for tax.
- Assuming all municipal interest is tax free, when some may be subject to alternative minimum tax or state tax.
- Assuming municipal bonds are free of risk, when prices move and some issuers default.
Questions
People also ask.
Who benefits most from a municipal bond fund?
Investors in higher tax brackets, because the tax exemption is worth more to them. A person in a low bracket may earn more after tax from a taxable fund.
Are the gains tax free too?
No, capital gains from selling fund shares or from gains the fund distributes are generally taxable. Investors should keep the fund's tax statements for their annual return.
What is the expense ratio?
It is the yearly cost of running the fund, shown as a percentage of assets, and it comes out of the income investors receive.
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