Tax-Exempt Bond Fund (Municipal Bonds)

What is a tax-exempt bond fund?

A tax-exempt bond fund (sometimes known as a municipal bond fund or muni bond fund) invests in tax-exempt municipal debt instruments issued by state governments or agencies, counties, cities, towns, or other political districts. From the shareholder’s point of view, the key feature associated with these funds is the advantageous income tax treatment they receive. This income tax treatment is generally the same as that enjoyed by holders of individual municipal bonds. Just as interest paid by municipal bonds is generally tax exempt at the federal level, so the income generated by municipal bond funds will also be free from federal income taxation.

Further, as with income produced by municipal bonds, the dividends paid by these funds may be exempt from state and local taxes as well. The dividends you received from a tax-exempt bond fund would likely avoid state income tax only in proportion to the percentage of total fund income attributable to securities issued in your home state. Any portion of income earned by securities issued outside your home state might be subject to state taxation.

The tax advantage means that, depending on your tax bracket, the after-tax return from a tax-exempt bond fund could actually be higher than that of a taxable bond fund.

Caution:  Keep in mind that while dividends derived from income may be tax exempt, dividends derived from capital gains are not.

Caution:  If you are subject to the alternative minimum tax (AMT), you must include interest income from certain municipal securities in calculating the tax unless the securities are specifically exempted from the AMT. For example, the American Recovery and Reinvestment Act of 2009 specifically exempts interest on private activity bonds issued in 2009 and 2010 from being included in AMT calculations.

What is a state tax-exempt bond fund?

As noted above, any state income tax advantage applies only to income from bonds issued in the taxpayer’s home state or local municipality. However, some tax-exempt bond funds, known as state tax-exempt bond funds or single-state muni bond funds, invest exclusively in debt instruments issued by a particular state. A California tax-exempt bond fund, for instance, holds only bonds issued by or within the state of California. For residents of the state that issues the bonds–in this case, California–income from the fund is free from both federal and state income tax; residents of other states receive the federal but not the state tax benefit.

If you live in a local municipality (for example, a city or town) that levies its own taxes, a portion of your fund income may avoid those taxes as well if some of the bonds held by the fund were issued directly by your municipality.

Tip:  There are state tax-exempt bond funds for almost every state in the United States.

When can it be used?

Tax-exempt bond funds may be suitable for somewhat conservative investors who want to invest in mutual funds without the volatility that may accompany stock funds and certain corporate bond funds. They are appropriate for investors seeking current income and for individuals in high tax brackets who want to minimize their income tax liability. Investors with more modest levels of income may not benefit as much from the tax treatment, however. The income they provide also can be used to help moderate volatility from other investments in a portfolio.

Strengths
Income tax benefits

The tax advantages are the greatest strength of tax-exempt municipal bond funds. Not only is the income generated by these funds free from federal taxation, but it may avoid state and local taxation in some cases as well. Investors may even enjoy triple tax-exempt treatment. This might occur, for instance, in the case of a New York City resident who would avoid federal, state, and city taxes on the portion of fund dividends representing income earned by New York City bonds. If you pick the right fund, these tax savings can significantly reduce your total tax bill. In general, the higher your tax bracket, the more attractive the tax benefits become.

Provides current income

Most bond funds seek to provide current income. However, these funds may provide a more reliable source of current income than most other bond funds. Even if you don’t need the extra income, you can still reinvest your dividends, or simply allow the income to help moderate the volatility of your portfolio

May carry lower risk than some other bond funds

Though it’s not impossible for state and local governments to default on bonds, the default rate on munis historically has been lower than that for corporate bonds (though past performance is no guarantee of what might happen in the future, of course). Because governments are generally able to raise taxes if necessary to pay their debts, muni bonds as a whole are considered a relatively conservative bond choice. And by investing in debt from a variety of issuers, a bond fund reduces the impact of possible default by a single governmental body.

Tradeoffs
Generally modest returns

The return on a given tax-exempt bond fund depends on several variables that affect municipal bond yields, including local economic factors and quality ratings assigned to specific securities. Because of their tax advantage, returns are generally expected to be lower than with other investments (though as noted above, the tax advantage also means that depending on an investor’s tax bracket, the net return could actually be higher than that of a taxable bond fund).

Susceptible to interest rate risk and inflation risk

When interest rates rise, bond prices fall. When interest rates go down, bond prices rise. Shares in a bond fund that you may have bought when interest rates were low can lose value as interest rates increase because the existing bonds in the portfolio aren’t as valuable as newer bonds that pay higher interest rates. (However, one advantage of having a bond fund is that the fund’s manager also can adjust the portfolio over time to take advantage of those higher-paying bonds.)

Inflation risk refers to the possibility that the return on your investments won’t keep pace with increasing price levels. As prices rise, the value of a dollar falls, resulting in a decreased ability to purchase goods and services. Bonds that offer a fixed interest rate assume this kind of risk. If the overall interest paid by the bonds in your fund is lower than the inflation rate, your investment dollars may not grow enough over the years to allow you to reach your financial goals. And if you rely on the fund for current income, those payments may lose purchasing power to inflation over time.

As with all bond funds, both tax-exempt and state tax-exempt bond funds never mature as an individual bond does. Therefore, they don’t offer the same assurance that your principal will be returned to you at some fixed future date. Before investing, carefully consider a fund’s investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing, as you would with any mutual fund.

State tax-exempt funds offer less diversification

The trade-off for receiving a greater tax advantage from a single-state muni fund focused on your state is the greater risk involved in a more narrowly focused fund. Because the fund’s holdings are limited to the bonds of one state, it has less protection from the impact of local economic problems. For example, if a state is heavily dependent on an industry that experiences an economic downturn, its finances (and those of the cities and towns in it) could be at greater risk of struggling to meet debt payments. If your job might also be affected by the same circumstances, that would put you doubly at risk.

Also, some states may have legal requirements that make it more difficult for a governmental body to raise taxes, even to pay its debts. Though diversification alone can’t guarantee a profit or ensure against a loss, municipal funds that invest in bonds issued by multiple states may offer greater diversification and more diluted risk.