Consider Municipal Bond Funds for Your Fixed Income and Cash Investments

September 9, 2008 by  
Filed under Investing, Retirement Planning

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

I don’t like what the government has done to the poor shareholders at Freddie Mac and Fannie Mae.  The shareholders were not the people who borrowed money that they couldn’t afford to pay back nor were they involved in the decisions to loan money to unqualified buyers.  The shareholders (including preferred shareholders) are getting the shaft.   But the hard truth is that the move was probably necessary as a long term economic strategy.  It’s time to move on and react in a way that favors your own investment outlook.

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.

Fund Trailing
Yield (%)
Ratio (%)
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.

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58 Responses to “Consider Municipal Bond Funds for Your Fixed Income and Cash Investments”
  1. Robert and all following this comment thread: It seems that news of the ever larger Obama stimulus package is making muni bond holders feel better about that sector. I would still be wary of non-diversified funds and special revenue bonds.

  2. john says:

    Dear ToughMoneyLove

    sorry about this question, Would you kindly commment on these nearly fixed income vehicles: – cprm or c-m, now priced ~ 15.5/share, called @ 2013 for 25 dollars/share, 8.5% annual return, graded A1 by Moody
    – citprc or cit-c priced @ 25.5, called @ 2015 @ 50dollars/share, annual 8.75% return, graded BBB by Moody you can buy one share or 10 millions shares in both cases once they are due they will turn into stock values prices for “C” and you can sell at that time

    I believe they are not FDIC but they are backed by their companies [although CDs at citibanks are fdic]

    Negatives are: the company can fail [which I don’t think will happen since ~60% of bad news are behind us, Stocks will probably go up next year anywhere from 30 to 100%, Gov will always bail them out since they are the backbone of the economy, the companies can “reduce” the annual rate [which I don’t think will happen] if they have bad profits/bad quaters {They still give the 8.75% even though through the sept/october of 2008 bad news quater}. These are consider somewhat aggressive but if a major thing occur, the Stocks companies usually will pay dividends for their bonds holder first, then the PREFERRED STOCK HOLDERS 2nd, then the stock holders last. They can cut rate of dividends for stock holders first but they don’t do it for bond holders or prefer stock holders if something happen to them [BAC did this when i bought their stocks]

    I think these are ok to include in your overall profolio. If my calculations are correct, you’ll gain 190% excluding tax if you hold citprc until 2015 when it’s due [if we don’t have any major black swan events]. It’s somewhat better than bonds because you have to spend a minimum of 5K for every new bond, but this one you can spend 25 dollars to buy one share or one millions to buy many shares so it’s a good vehicle investment strategies.

    Thank you for your suggestions about these vehicles.

  3. Robert says:

    Muni’s were doing so well over the last two weeks…gaining back previous losses. Now, they’re moving south again. What causes this and do you advise holders stay the course or bail before blood hits the floor?

    Thank you TML

  4. John: I’m sorry for the delay in responding to your comment. I don’t know anything about the fixed imcome vehicles that you ask about. They sound like convertible bonds but even those can vary widely in their important provisions. You need to read the fine print carefully and also determine if you intend to hold them to maturity. If so, you also need to look at whether the issuer has the right to redeem them earlier, thereby taking away some of the benefit you get for the risk you are taking.

  5. Robert: I think muni’s will remain volatile as long as we continue to hear bad news about the financial condition of state and local governments. Until then, munis will probably track the general ebb and flow of the equity markets as a whole, as investors are still operating more on emotion and less on logic.

  6. Jean says:

    Hi Robert,

    My take on this is that in both stock and bond markets people are taking profits as the opportunity arises, having sustained loses that they are trying to ameliorate. Since muni funds are essentially liquid, they are prone taking hits. Shareholders selling off affects the entire fund negatively – at least in the short term. I also think that as the political and economic situation stabilizes, investors will regain confidence and more investment will take place for growth. Those of us in higher tax brackets still see municipal bonds as a good investment.
    As John has emphasized, some states are, however, in a more difficult situation than others. Stalwart states have a better chance of rebounding sooner.

  7. Kristi says:

    My parents have most of their money in ETAZX Eaton Vance Arizona Muni Bond fund. They have been in the fund for 19 months. They are living on the dividends. Can you recommend a fund that is safer? Morningstar downgraded it from 3 to 2 stars a few months ago. They need to make 4.5% dividends or better. My parents are 80 years old so a short term view is best. They have lost nearly 10% in value in the past 19 months. Should they just get out and put it in a cd?

  8. Boss says:

    TML and Matt, Many thanks for your helpful counsel and I did sell all the CA Vanguard Munis. The losses totally offset our capital gains from D&C. One year like this I will survive but if we have another I may decide to put it under the mattress or into gold coins. This comment to #57 (Kristi). We are of similar age to your parents and have moved bond money to CD’s. If taxes are not a big issue you might want to check VeriBanc for safe banks and also their CD service. What ever you decide do not let them get involved in a reverse mortgage. Good Luck!

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