If you’re looking for a safe investment that is likely to deliver slow yet steady returns over the long haul, and where you don’t have to pay federal or local taxes, a tax-free municipal bond might be a good option. In order to avoid local taxes, simply invest in a local (city or state) municipal bond. If you invest outside of your own area you might have to pay taxes, which wouldn’t make a tax free municipal bond as appealing as some other safe investment options, such as corporate bonds or certificates of deposit (CDs). (For more, see: The Basics of Municipal Bonds).
There are four big benefits to investing in a tax free municipal bond exchange-traded fund (ETF): liquidity, diversification, safety, tax free. As far as liquidity, unlike open-end municipal bonds or individual municipal securities, tax free municipal bond ETFs allow you to move in and out of your position if necessary. There are also no front-end or back-end sales charges. And expense ratios are lower. This last point plays a big role in choosing the right tax free municipal bond ETF. What follows below should help guide you in the right direction (numbers are as of Jan. 30, 2015).
Tracks: S&P National AMT-Free Municipal Bond Index
Average volume: 298,075
Inception date: September 7, 2007
Expense ratio: 0.25%
Net assets: $4.39 billion
Annual dividend yield: 2.69%
3-Year Total Return: 2.92%
Tracks: Barclays Municipal Managed Money Index
Average volume: 427,521
Inception date: September 11, 2007
Expense ratio: 0.23%
Net assets: $1.22 billion
Annual dividend yield: 2.33%
3-Year Total Return: 3.76%
Tracks: Barclays Managed Money Municipal Short Term Index
Average volume: 574,854
Inception date: October 10, 2007
Expense ratio: 0.20%
Net assets: $2.45 billion
Annual dividend yield: 0.92%
3-Year Total Return: 1.19%
Tracks: Barclays AMT-Free Continuous Municipal Index
Average volume: 36,897
Inception date: February 22, 2008
Expense ratio: 0.20%
Net assets: $274 million
Annual dividend yield: 1.20%
3-Year Total Return: 1.18%
80,000+ Municipal Bonds
With more than 80,000 issuers of municipal bonds in the United States, you have many more options than the tax free municipal bond ETFs listed above. Just keep in mind that these ETFs offer a lot more diversification. (For more, see: Top 2014 Muni Bond ETFs).
Revenue bonds are issued by transportation systems, hospitals, power systems, sewer systems, water systems and the like. These bond issuers generate revenue by selling tickets and collecting on bills. Part of this revenue is then returned to you, the investor.
General obligation bonds are issued by states, cities, towns, school districts and so forth. The bond issuer relies on taxes to in order to repay the bonds. Taxes can mean income taxes, corporate taxes, property taxes, sales taxes, excise taxes and more. So instead of complaining about taxes perhaps it’s time to invest in municipal bonds, which will be tax free (in most cases), and allow you to collect on other people’s taxes. (For more, see: Avoid Tricky Tax Issues on Municipal Bonds).
The Bottom Line
It would be difficult to go wrong investing in tax-free municipal bonds or municipal bonds in general for that matter. However, the former provides you with a lot of diversification. (For more, see: Why You Should Invest in Municipal Bond ETFs).
Dan Moskowitz does not have any positions in MUB, TFI, SHM, or SMB.