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While junk bond funds grabbed the headlines for biggest fixed-income loser in 2015, municipal bond funds sneaked under the radar to take the crown as leader. But will 2016 be a repeat year for muni bonds and what exactly are their benefits?
The average high-yield bond fund fell 4% in 2015, while the average municipal bond fund climbed 3%. Yes, past performance is no guarantee of future results, but the same general risk factors for bonds in 2015 will likely remain for much of 2016, if not the entire year and beyond.
Investors are in risk-off mode as they question the resilience of the U.S. economy while global economies soften. And in the face of a bear market for stocks, junk bonds can see stock-like declines. So, understandably, investors looking for yield may be willing to trade off high yields and potential big losses of principal with junk bond funds for the low yields and maintaining – or even gaining – principal with boring municipal bond funds.
The Benefits of Municipal Bond Funds
For 2016, the first benefit of municipal bond funds may prove to be their price stability compared to junk bonds. But many investors tend to overlook the benefits of muni bonds that are constant.
Municipal bonds are issued by state and local government entities. To encourage the purchase of these debt obligations, interest income received by holders of municipal bonds can be excluded from gross income for federal income tax purposes. And depending on the applicable state income tax laws, the interest income may also be exempt from state income tax as well.
Therefore, the most fundamental benefit of municipal bonds, as compared to corporate bonds, is the potential for tax-free income. But this tax benefit is better from some investors than it is for others.
Who Benefits Most From Municipal Bond Funds?
All income from municipal bond funds is generally free from federal income taxation. However, the interest is tax free at the state level only if the fund owns municipal bonds issued in the home state of the investor.
For example, an investor living in California, who is a shareholder of a New York municipal bond fund, won’t receive the tax-free benefit at the state level, although he can still qualify for tax-free income at the federal level.
The investors who benefit the most from holding municipal bonds and municipal bond funds are those that pay at higher tax rates.
Calculating Tax Equivalent Yield for Municipal Bonds
A good way to determine the tax benefit of municipal bonds is to calculate what is called the tax-equivalent yield. For example, let’s say an investor that is in the 35% tax bracket is considering investing in a corporate bond that yields 4% or a municipal bond that is yielding 3%.
The next step is to plug in the numbers for the tax-equivalent yield calculation, which is the municipal bond yield divided by one minus the investor’s tax rate, like this:
Tax-Equivalent Yield = 0.03 / (1 – 0.35) = 4.62%
In this scenario, the investor would be smart to choose the municipal bond. And the tax-equivalent yield would be even greater if the investor lives in the applicable state.
For more reference, an investor in the 25% federal tax bracket would have a 4% tax-equivalent yield on the municipal bond, which is identical to the corporate bond. Investors in the 15% bracket or below would not benefit from the tax break, especially if they buy municipal bonds from states or municipalities outside of their own.
The same general benefits apply to municipal bond mutual funds and ETFs. And like most other scenarios with investing – especially with bonds and bond funds – it is wise to buy no-load funds with low expense ratios, such as those offered at Vanguard, Fidelity and T. Rowe Price.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. Under no circumstances does this information represent tax advice or a recommendation to buy or sell securities.