It happens every year. You can’t avoid it. And every year you vow to make some changes: Taxes.

Why not use every legitimate tool to reduce them, particularly if it is comparatively easy to do so?

If you are in a higher federal income tax bracket—25% or more—and your portfolio currently generates income from bonds, CDs or other fixed-income investments that are not in tax-deferred accounts, then you should contemplate switching to a federal tax-exempt income source.

And the easiest source of federal tax-exempt income is a municipal bond fund.

The Tax-Equivalent Yield Box shows you how to calculate the benefit you’d receive from making the switch.

Returns: More Than Income

Mutual fund returns are total returns, however, as shown in Table 1 and include both interest income and capital gains (losses), if any.

Capital gains that are short term—whether on bonds held by the fund or mutual fund shares held by the investor—are taxed at ordinary income tax rates and are not exempt from federal taxes.

Long-term gains on bonds held by the fund for more than one year or long-term gains on municipal bond fund shares held by an investor for more than a year are taxed at the federal level at long-term capital gains rates.

State-specific municipal bond funds also offer the potential for an additional exemption from state and local taxes—a particularly important exemption in a high tax state such as New York. [See AAII’s annual Guide to the Top Mutual Funds for a listing of state-specific municipal bond funds (sent to all members in March).]

The municipal bond funds in Table 1 are all national municipal bond funds and hold bonds from across the nation. The income received on bonds issued from your state that are in these national municipal bond funds, however, may qualify for exemption from your state or local income taxes. Check with each bond fund or family to determine your potential income exemption at your state and local level. But a warning: State and local tax laws are arcane (as if you didn’t know it already).

The national municipal bond funds reported on by the Guide to the Top Mutual Funds are grouped by maturity in the table.

Maturity Matters

Look over to the average maturity column: This is weighted by the value of the portfolio bond holdings at each maturity, and you can see that while the general categories and the fund names provide some guide to maturity, the variations within a category and fund name can be wide.

Is maturity that important?

Yes.

A quick glance down the five-year average annual total return column and your general conclusion is probably that longer maturities produce, on average, higher returns. The same is generally true for yields, a measure of your federal tax-exempt income.

But there is a price to be paid for higher returns, and that is volatility. Study the 1999 and 2000 returns for a moment. When interest rates rise—as they did in 1999—the prices of existing bonds fall and total returns decline, perhaps going negative as capital losses swamp interest income. The longer the maturity of the bond fund, the greater the impact. When rates fall—or there is a rush to bonds from stocks, as happened in 2000—the reverse happens: Total returns rise as capital gains are added to interest income.

Risk Measures

The total risk index compares the individual fund to all funds, bond or stock; the index average is 1.00. As you can see, these bond funds relative to all mutual funds have low risk, but the risk does increase, on average, as maturity lengthens. This risk is also evident when viewed through the category risk index, in which individual funds are compared with other funds in the same category. The average risk index for a fund in a category is 1.00. A 1.25 category risk index implies that the fund’s returns are 25% more volatile than the category average.

In this table, the categories for the category risk index are short, intermediate and long-term national municipal bond funds. For example, Vanguard Limited-Term Tax-Exempt has a category risk index of 1.53, substantially more than the category; this is consistent with its average maturity of 2.9 years, which is the longest maturity of that category.

However, the relationship between the category risk index and maturity is not perfect because other differences in the bonds held in a portfolio can affect volatility, including differences in coupon rates (the stated interest rate paid on the bond annually), call features or the presence of variable coupon rate issues.

Duration is a mathematical risk measure—essentially a measure of sensitivity to interest rate changes—that captures all these portfolio and individual bond characteristics. Simply stated: The higher the duration of a bond fund, the higher the risk. High coupon rates and shorter maturities lessen duration, while longer maturities and lower coupon rates make duration greater. The Duration Box provides an easy rule for using duration when analyzing a bond fund.

Finally, in terms of risk, the portfolio average credit quality is worth a look. Lower-credit-quality bonds can impact a portfolio if a state or municipality’s economic situation deteriorates, requiring more debt to be issued or imperiling the interest payments on current outstanding debt.

The average credit quality is listed for these municipal bond funds, with AAA the highest and BAA the lowest investment grade; anything below falls into the “junk” category.

Lower average credit quality—A rather than AAA, for example—increases yields because bond issuers with lower ratings are less financially secure and are forced to pay higher interest to offset greater bondholder risks.

The Strong Short-Term Municipal Bond Investment fund carries the lowest quality average and has the highest yield in its category, but a relatively low duration, because high yields on lower-credit-quality bonds push duration down.

The Right Choice

Are municipal bond funds the right choice for you?

Ask yourself these questions:

• Are you in a relatively high federal income bracket, or do you reside in a high income tax state or municipality?
• Do you have interest income from investments that are not in tax-sheltered accounts, such as 401(k)s and IRAs?
• Do you want interest income exempt from federal and perhaps state and local income taxes?

John Markese is president of AAII.