Consider Municipal Bond Funds for Your Fixed Income and Cash Investments
Warning: Municipal bonds can be boring. But, if you are looking to squeeze a little more yield out of your fixed income and cash-equivalent investments, keep reading. But while you are reading, be sure you monitor all of the developments in the market that have occurred in 2008 and 2009.
Freddie Mac and Fannie Mae Keep Us Thinking Ahead
Yesterday’s announcement caused smart investors to re-think their asset allocations, particularly as to investments that are sensitive to interest rate and credit risks. With interest rates remaining depressed by Fed action, finding reasonably safe places to invest your cash and receive decent yields is a difficult task.
Yesterday I talked about high interest rate (5%) online checking accounts offered by some community brick and mortar banks. Some Internet savings bank loyalists questioned my sanity on those thoughts but that’s OK, they can keep their 3% pre-tax yield at ING Direct and its competitors.
Municipal Bond Funds Give You the Tax-Free Edge
Today Mr. ToughMoneyLove wants to mention municipal bond funds, which have been disfavored in recent years because their yields, although tax free, have not compared favorably with other low-risk, fixed income and cash-equivalent investments, including money market funds, CD’s and Treasury funds. The pendulum seems to have swung a little and it may be time to reconsider municipal bond funds in the fixed income and cash portions of your taxable accounts.
Let’s compare trailing yields on two name brand, low cost funds: Vanguard Long-Term Tax Exempt (VWLTX) and Vanguard Long Term U.S. Treasury (VUSTX). VWLTX has a current tax-free dividend yield of 4.62% and an expense ratio of 0.15%. For someone in the 28% tax bracket, that’s an equivalent yield (compared to a taxable bond or fund) of 6.42%. VUSTX by comparison has a current dividend yield of 4.56% and an expense ratio of 0.26%. Both funds require a $3,000 minimum investment. VUSTX is even beating the tax equivalent dividend yield (5.15%) of one of my favorite inflation protected security funds, VIPSX.
Granted that Treasury funds are no-risk investments but the municipal bond fund is close. Considering that the average default rate of high quality municipal bonds is only 0.01%, the risks are negligible and well worth the 1.8% effective interest rate premium. (Earning an additional 1.8% is nothing to sneeze at in today’s economy.) I have listed several other similar tax free muni funds below.
|Fidelity Municipal Income (FHIGX)||4.15||0.44||$10,000|
|Fidelity Tax-Free Bond (FTABX)||4.06||0.18||$25,000|
|Franklin Federal Tax-Free Income A (FKTIX)||4.52||0.60||$1,000|
You Can Also Avoid State and Local Income Taxes
If you are in a state with high state and local income tax rates (sorry New Yorkers and Californians), you may want to look for a municipal bond fund that owns bonds issued only in your state, which would be exempt from state and local taxes as well.
If you have the cash to invest in larger lump sums (not me), you can buy individual municipal bonds. A good resource for finding and pricing municipal bonds is on EMMA, a market site published by the Municipal Securities Rulemaking Board. (EMMA also features information about 529 College Savings Plans.)
Watch Out for the Alternative Minimum Tax
If you decide to buy an individual bond, I suggest that you look for a high-yield housing bond. These bonds were given special favorable treatment in the recently passed Economic and Housing Recovery Act of 2008, meaning that the Alternative Minimum Tax (AMT) will not apply to their interest payments. (There are lots of these “tax tweaks” in this 700 page law, most of which are not favorable to folks with money. This tweak is OK.)
Another option if you are concerned about the AMT is to buy a muni fund that owns only non-AMT bonds. T. Rowe Price Tax-Free Income Fund (PRTAX) is one example of such a fund. It yields 4.54%, has an expense ratio of 0.52%, with a minimum investment of $2,500.
Most of these funds have three-year and five-year average annual returns (in addition to dividend yields) in the range of 3-5%. Obviously, if interest rates increase, the market value of these bonds and funds will fall. At that time, you can sell and move into something else or you continue to hold them and collect the high dividend yield on your investment.
The Hard Truth Bottom Line
For best yields on fixed-income and cash equivalent investments in today’s market, you need to think and look beyond your comfort zone of money market funds, CD’s, and Internet bank savings accounts. If you are in a higher tax bracket, municipal bond funds should be on your list of options to consider. Make sure you factor in transaction costs when evaluating this strategy. Also, keep a close eye on what the Fed does because when they start ratcheting interest rates up, you will need to make a move in another direction.
Anyone have other suggestions for higher yielding cash equivalent investments?
Update 2009: Muni bonds have not performed well in 2008-2009 and carry increased risk. There are some municipal bond funds that have lower risk than others.