Pin Me

Investing in Municipal Bond Funds

written by: Bruce Tintelnot•edited by: Jason C. Chavis•updated: 11/15/2010

Fixed-income assets can be an important part of any well balanced investment portfolio. Investing in municipal bond funds are considered among the lowest risk in the market and can be a valuable addition. There are some things to be watching for when considering them.

  • slide 1 of 8

    Bonds are usually the first investment that comes to mind when people think of investing conservatively. Reducing risk and increasing returns are usually of paramount importance to them. The mutual fund is an investment vehicle that was created to achieve this is, and many of them have bond funds that deal exclusively with investing in municipal bonds (munis).

    Investors consider investing in municipal bond funds to balance their portfolio against the higher risk investments that are in it. Also, those in a high tax bracket can stand to realize more gains for two reasons:

    • Many municipal bonds are tax-free.
    • The diversification of the fund's holdings reduces most of the risks that all bonds are exposed to.

  • slide 2 of 8

    Tax Exempt

    Municipal bonds (munis) are issued by states, counties, cities, and municipalities governments to raise funds to improve roads, refurbish public buildings, and other capital expenditures. The U.S. Constitution forbids the federal government from taxing the interest earned on the obligations of states and municipalities. This tax-free feature provides an income that is greater for the higher income brackets than for the lower ones.

    Comparing the pretax yield of a taxable bond to that of a tax-free bond is called the Tax-Equivalent Yield. An equation has been developed to calculate this:

    Tax Equivalent Yield = Tax-Free Municipal Bond Yield ÷ 1 – Tax Rate

  • slide 3 of 8

    Interest Rate Risk

    Riskfree Another idea makes investing in municipal bond funds popular, like other mutual funds, is that the diversification of their bond holdings lessens the affects of risk factors like leverage risks, credit risks, and foreign exchange risks. An exception to this is interest rate risk.

    Changing interest rates is the risk that municipal bond funds, and all bond funds, are least protected from by diversifying their holdings. When interest rates go up, bond prices go down, and the reverse is also true. An indicator that has been devised to measure the sensitivity of bond funds, or fixed-income investments, is called duration. This is a complex formula and is a standard value that is included in most information offered to investors by bond funds. A high duration indicates that a bond fund is more sensitive to changes in interest rates, and the potential for short-term gains and losses is greater.

  • slide 4 of 8

    Other Things to Know

    • 500px-US states by average state tax income percent svg Other things to know when shopping for municipal bond funds are:

      - Your state's tax rate.
    • - Costs associated with a muni fund.
    • - Does the fund include bonds that are subject to the Alternative Minimum Tax?

    Some municipal bond funds invest in municipal bonds from across the United States. These are only tax-exempt at the federal tax level. These funds are only tax-free at the federal tax level, but they offer the risk reducing advantages that comes with diversification.

    Single-state municipal funds offer tax-free income on the state, and federal levels. Investors living in a high-tax state would probably benefit from investing in a state municipal fund when compared to a national one.

    Municipal bond funds within a state can also offer "triple-tax-free" interest payments to investors. This means that income from these obligations is tax free at the federal and state levels, and whatever levels the issuers happens to be at within the state.

    Costs are another important factor to be considering when looking at municipal bond funds as an investment due to their low yields. A 1.1% expense ratio compared to a Yield to Maturity (YTM) of 4.5% is a rather high overhead cost to be looking at. Funds with expense ratios less than 1% are what many investors look for.

  • slide 5 of 8
    Investing in municipal bonds bring tax-free returns but some of them are subject to the Alternative Minimum Tax (AMT) which can reduce the return on investment (ROI).
  • slide 6 of 8

    Alternative Minimum Tax

    Municipal bond funds that invest in bonds that are considered to be funding a "private activity" can be subject to the Alternative Minimum Tax (AMT). This adds another burden to the costs of municipal bonds, and is one that some investors would like to avoid. These bonds carry a slightly higher interest rate, and are used to fund hospitals, housing, and attract companies in the private sector. Many mutual funds offer non-AMT bond funds; these are funds that exclusively invest in bonds that avoid the AMT.

  • slide 7 of 8

    Summary

    Municipal bond funds can be a good addition to the portfolios of investors in the higher tax brackets. The high tax combined with the tax-free feature can magnify the low yields that are attached to them to produce higher returns on the investment (ROI). These can be reduced by the costs that a fund can incur, such as, a high expense ratio greater than 1%, and the Alternative Minimum Tax (AMT).

  • slide 8 of 8

    Resources

    Author undisclosed, “Evaluating bond Funds: Keeping It Simple." Articles/Mutual Funds, 2005.Investipedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/articles/mutualfund/05/062805.asp

    Jason Van Bergen, “Weighing The Tax Benefits Of Municipal Securities," Articles/04, 2010. Investopedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/articles/04/072804.asp

    Author undisclosed, “Triple-Tax-Free," Dictionary, 2010. Investipedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/terms/t/tripletaxfree.asp

    Author undisclosed, “Municipal Bond Fund," Dictionary, 2010. Investipedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/terms/m/municipalbondfund.asp

    Author undisclosed, “Tax-Equivalent Yield," Dictionary, 2010. Investipedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/terms/m/municipalbondfund.asp

    Author undisclosed, “Duration," Dictionary, 2010. Investipedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/terms/m/municipalbondfund.asp

    Author undisclosed, “Weighted Average Maturity - WAM," Dictionary, 2010. Investipedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/terms/m/municipalbondfund.asp

    Author undisclosed, “Alternative Minimum Tax - AMT," Dictionary, 2010. Investipedia.com. Retrieved August 15, 2010 from the World Wide Web: http://www.investopedia.com/terms/m/municipalbondfund.asp

    Author undisclosed, “Muni-Fund Considerations," Funds 300, 2010. Morningstar. Retrieved August 15, 2010 from the World Wide Web: http://news.morningstar.com/classroom2/course.asp?docid=3062&page=3&cn=com

    Author undisclosed, “Munis," Funds 300, 2010. Morningstar. Retrieved August 15, 2010 from the World Wide Web: http://news.morningstar.com/classroom2/course.asp?docid=3062&cn=com&page=1

    Aleksandra Todorova, “Chasing Muni Yields Carries Risks," 2008. SmartMoney. Retrieved August 15, 2010 from the World Wide Web: http://www.smartmoney.com/spending/deals/chasing-muni-yields-carries-risks-23041/