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Beginner’s Guide to Municipal Bond Mutual Funds

The municipal bond market is very large, sitting at $3.7 trillion as of 2013, and represents 10% of the entire U.S. bond market, behind only Treasury bonds (29%), corporate bonds (24%), and mortgages (21%). To put this into perspective, as of September 30, 2014 the entire Nasdaq had a market cap of $6.7 trillion.
Municipal bonds mutual funds invest in municipal bonds or “munis.” Municipal bonds are issued by states and local governments to fund public projects. What makes the investment unique is that they are generally tax exempt from state taxes for residents of the state in which they are issued and from federal taxes.

Essentially, an investor would be loaning money to the local government in exchange for interest payments over a pre-determined period of time, and at maturity the investor would receive their investment back. In terms of risk, they involve more risk than Treasury bonds, but less risk than corporate bonds. They are particularly good for investors seeking high current income exempt from federal income tax and the preservation of capital.

Be sure to also see the 25 Tips Every Mutual Fund Investor Should Know.

How Municipal Bond Funds Can Be Used in a Portfolio

Municipal bond funds are added to a portfolio because the interest paid is generally tax exempt; total returns can be potentially higher than taxable bond funds; and municipal bonds have lower risk than corporate bonds. Moreover, they are an attractive choice if bonds are part of your asset allocation plan and if you’re willing to take on more risk for a higher return compared to Treasury bonds. They can also be a good choice if you have an insider’s knowledge of your municipality’s prospects, knowing what infrastructure is being built and what would be required.

See also our Beginner’s Guide to Bond Mutual Funds.

Investors may ask then when is a good time to buy into municipal bonds? A good time can be if you expect interest rates to decrease in the future (locking in the interest rate and increasing the value of the bond if you choose to resell). A good time to get out, on the other hand, can be if you expect interest rates to increase, or if you are concerned about the financial health of the issuer.

Types of Municipal Bond Funds

Municipal bonds funds can focus on any state and any municipality. They can be region focused, high yield, or high quality focused. Among these types there are two different kinds of municipal bonds that municipal bond funds invest in.

General Obligation Bonds
These are issued by government entities and are not backed by revenues from a specific project or source. They are instead backed by dedicated taxes on real property and, depending on the situation, other taxes. Other general obligation bonds are often referred to as backed by the “full faith and credit” of the government.

Revenue Bonds
These municipal bonds are backed by revenues from a specific project or source.

Both types are tax exempt and are particularly attractive to investors seeking capital preservation.

Benefits of Owning Muni Bonds Through Mutual Funds

Municipal bonds are typically seen as a conservative investment strategy, but they are not without risk. There can be credit risk, interest-rate risk, call risk, and market risk. Holding a municipal bond mutual fund can help diversify some of these risks that otherwise an investor would be overly exposed to.

Credit Risk
This is the risk that the issuer cannot meet its financial obligations, like what happened with Detroit. It’s rare for a municipality to default but it can occur. To aid in the evaluation of a lender’s creditworthiness, rating agencies such as S&P and Moody’s rate their debt obligations.

Interest-Rate Risk
The risk that interest rates will rise causing the bond you own to be paying a lower yield than the market and thus losing out due to the opportunity cost.

Call Risk
Call risk is the risk that the lender will pay back its debt prior to maturity. This can be unexpected and would mean the end of the income stream sooner than desired. Usually there is a premium paid to the investor for the early debt retirement.

Market Risk
Market risk is not applicable if holding the municipal bond to maturity, but if an investor chooses to sell before maturity, whether interest rates have increased or decreased will affect the market price of the municipal bond.

Tax Considerations

The key feature of municipal bonds is that the income stream is tax free in the jurisdiction in which the bond was issued. Investors should be aware that if, for example, an investor purchases a New York municipal bond but lives in a different municipality, they would only qualify for tax-exemption at the federal level; the state or local level may still be taxed in this scenario.

Another thing to consider is capital gains and losses. If an investor holds a municipal bond and interest rates drop and the bond price increases resulting in a capital gain, and an investor resells the bond, then the capital gains will still be taxed at the federal level. Just remember that the interest income stream is tax free, not the capital gains. Capital gains are not a concern if the municipal bond is held to maturity.

See also 7 Essential Tax Tips for Mutual Fund Investors.

Biggest Municipal Bond Funds

Just as with mutual funds, there are many different kinds of municipal bond mutual funds. Here are some of the top rated according to Morningstar:

High Yield Muni: T. Rowe Price Tax Free High Yield Fund (PRFHX)
Summary: High-yield portfolios invest at least 50% of assets in high-income municipal securities that are not rated by a major agency. The fund buys junk bonds (non-investment grade) and may buy them in default as long as they do not exceed 10% of the fund’s total assets.

  • Total Assets: $3.02B
  • 2014 Return: 12.2%
  • MER: 0.68%
  • Risk: Average

Muni California Intermediate: Vanguard California Intermediate Term Tax Exempt Fund (VCAIX)
Summary: Muni California intermediate/short portfolios invest at least 80% of assets in California municipal debt. Because the income from these bonds is generally free from federal taxes and California state taxes, these portfolios are most appealing to residents of California. Duration is less than 12 years.

  • Total Assets: $8.22B
  • 2014 Return: 6.8%
  • MER: 0.20%
  • Risk: Above Average

Muni National Long: Vanguard Long-Term Exempt Fund (VWLTX)
Summary: Muni national long portfolios invest in bonds issued by various state and local governments to fund public projects. The income from these bonds is generally tax -free from federal taxes. Duration is more than 12 years.

  • Assets: $8.34B
  • 2014 Return: 9.2%
  • MER: 0.20%
  • Risk: Rising interest rates; as rates rise bond prices fall

Muni New York Long: Vanguard New York Long Term Tax Exempt Fund (VNYTX)
Summary: The fund invests primarily in high-quality municipal bonds issued by New York state and local governments, as well as by regional governmental and public financing authorities. Because the income from these bonds is generally free from federal taxes and New York state taxes, these portfolios are most appealing to residents of New York.

  • Assets: $3.46B
  • 2014 Return: 9.1%
  • MER: 0.20%
  • Risk: Below Average

The Bottom Line

Municipal bond funds can have a positive impact on an investor’s income stream and portfolio returns. As with any investment, proper due diligence should be conducted first to see if the fund aligns with your own tax considerations and the MER of the fund; the lower the better. With all of that considered, municipal bonds can be a great part of an investment portfolio for investors.

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Nov 28, 2014