Muni Bond Funds' Additional Advantage

Municipal (muni) bond funds have an additional advantage over similar taxable bond funds beyond their tax-advantaged yields. Muni bond funds have also realized higher returns, according to a study published recently in The Wall Street Journal.

The tax advantage comes from the types of bonds held. Muni bond coupon (interest) payments are not taxed at the federal level. Depending on the issuer and where you reside, they may also be exempt from state and local taxes (SALT). These advantages flow through to investors who own muni bond exchange-traded funds (ETFs) and mutual funds.

The tax-equivalent yield matters more than the quoted yield for a muni bond or bond fund for this reason. The tax-equivalent yield is the yield you realize after taxes are considered. Put another way, it shows you how much interest income you get to keep on an aftertax basis.

Once you adjust the yield, muni bond ETFs and mutual funds look more attractive relative to similar taxable bond funds. Consider intermediate-term bond ETFs. The average yield for the muni national intermediate ETF category is 3.5%. This equates to a tax-equivalent yield of 5.6% for an investor in the 37% tax bracket [0.035 ÷ (1 – 0.37)]. In contrast, the average yield for the intermediate core bond ETF category is lower at 4.3%.

(Tax-equivalent yields are also used for comparing a muni bond against a similar taxable bond.)

George Mason University professor Derek Horstmeyer believes that most investors are better off going with muni bond funds when returns are also factored into the decision-making process. Horstmeyer and his research assistants compared the universe of domestic muni mutual funds against similar taxable bond funds. (State-specific funds were excluded.) Horstmeyer and his assistants considered fees, credit ratings and average maturity, among other factors, to better compare the two types of funds against each other.

Overall, the return for the average muni bond has been 3.32% on annualized basis over the past 15 years, according to Horstmeyer. Comparable taxable bond funds realized just a 1.54% aftertax annualized return. (The returns shown in the tables above are for the broad categories, whereas Horstmeyer’s analysis matched similar types of funds.)

The returns are based on the 37% tax rate. What’s notable, given the comparatively smaller tax savings, is that the tax-exempt muni bonds outperformed even at the 10% marginal tax rate.

There was one exception: short-term bond funds. “If you are below the 32% marginal tax-rate level, then it is usually better to invest in a taxable bond fund,” wrote Horstmeyer.

None of this analysis considers Medicare premiums or tax-preferred accounts. Muni bond interest realized in taxable accounts is added back into modified adjusted income when calculating the Medicare income-related monthly adjustment amount (IRMAA).

Bond interest earned in individual retirement accounts (IRAs), Roth IRAs, 401(k) plans and similar types of accounts is not taxed. The tax-equivalent yield therefore does not apply in such cases.