Munis: A Less-Taxing Alternative

06/12/2014 9:00 am EST

Focus: FUNDS

Richard Moroney

Editor, Dow Theory Forecasts

Interest on municipal bonds, issued by states, municipalities, and quasi-governmental entities such as airports and water systems, is generally immune from federal income tax, explains Richard Moroney, editor of Dow Theory Forecasts.

When comparing muni bonds to taxable bonds, we typically adjust the stated yield based on the highest individual income-tax rate (39.6%) to compute a tax-equivalent yield comparable to the stated pretax yields of taxable bonds.

Even without their tax advantages, munis look better than usual relative to other bonds. As of May 29, The Bond Buyer's 20-Bond Index of municipals yielded 4.26% (equating to a tax-equivalent yield of 7.05%), down from 4.73% at the start of the year, but roughly in line with the five-year average of 4.25%.

The current yield lags the 20-year average of 4.91%, no surprise given the Fed's anchoring of the yield curve at the short end.

At the moment, municipal bonds look somewhat expensive relative to their 20-year average yield. However, Treasury and corporate yields have fallen more sharply from long-run averages, making munis appear cheap in comparison.

Over the last 20 years, Baa-rated corporate bonds have averaged a yield 2.06% above that of the 20-Bond Index. However, that spread shrank to an average of 1.29% over the last five years and 0.34% as of May 29, the tightest spread in, at least, 60 years.

Our take: We prefer stocks to bonds for the year ahead. But if bonds make sense for you, municipals look like a wise choice—assuming you keep your bonds in a taxable account and can take full advantage of munis' tax protection.

Investors seeking exposure to municipal bonds should look at the six national municipal bond funds below that all earn high scores in our rating system.

All have topped the average return for their group over the last one and three years. All pay above-average yields and charge below-average expenses.

Among short-term municipal bond funds, Fidelity Ltd. Term Municipal Income (FSTFX:US) and USAA Tax Exempt Short-Term (USSTX:US) both offer a tax-equivalent yield of 1.1%.

Among intermediate-term muni funds, Vanguard High-Yield Tax-Exempt (VWAHX:US) offers a tax-equivalent yield of 4.8%, while Vanguard Intermediate-Term Tax-Exempt (VWITX:US) offers a tax-equivalent yield of 3%.

Among long-term municipal bond funds, Fidelity Tax-Free Bond (FTABX:US) offers a tax-equivalent yield of 4% and Vanguard Long-Term Tax-Exempt (VWLTX:US) offers a tax-equivalent yield of 4.3%.

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