Questions to Ask Before Investing in Municipal Bond Funds

Two investors asking an advisor about mutual funds

Westend61 / Getty Images

Municipal bond funds are mutual funds that hold the tax-free investments known as municipal bonds, or muni bonds. For a particular class of investors, one with a sizable tax burden but less than $100,000 to invest, muni bond funds may be the perfect buy.

If you're thinking about buying a muni bond fund, there are a few key things to consider.

Would You Do Better With a Taxable Fund? 

Because of the tax-free nature of muni bonds, issuers can offer a lower yield and still attract buyers. As a result, the yields on tax-free muni bonds tend to be lower than the yields on taxable funds. But depending upon your tax bracket and the state in which you live, you may be able to get a better return after taxes by buying a taxable fund, paying Uncle Sam, and pocketing the difference.

What's the Tax Situation in Your Home State? 

All muni bonds are free of federal taxes, with few exceptions. But only the bonds issued in your state are free of state taxes. Interestingly, all bonds issued by U.S. territories like Puerto Rico and Guam are tax-exempt. So look carefully at available funds. If the taxes in your state are low, you may do better with a taxable fund. More importantly, if you live in California and buy a fund full of New York munis, you won't save a penny on state and local taxes.

Can You Predict the Future? 

Most of us are willing to make educated guesses about the future of the economy and our personal finances. But few of us are willing to bet our futures on our ability to see the future. So exercise caution. Muni bond funds, just like all debt investments, move in the opposite direction of interest rates. So just as the price of a municipal bond falls when interest rates climb, the share price in muni bonds will decline amid rising rates based upon the duration of the bonds in the fund. In other words, a fund that's filled with bonds that mature many years into the future is more vulnerable to interest rate swings than a fund with intermediate bonds.

What Am I Paying for This?

When choosing a muni bond fund, pay particular attention to fees. Muni yields are generally lower than those on taxable investments, and large fees can easily eat up the difference in profit after taxes. Avoid paying commissions to brokers and advisers. Look for no-load funds. Stick with a fund that has an expense ratio of less than 1%

What Sort of Returns Are Available? 

Past is not prologue. But you should still look at how well a muni fund has done in the past before deciding its future potential. If you're wondering what is the best muni fund for your needs, consider how well a fund has done in recent years. Information on fund performance is widely available through major investment institutions and through websites such as MSN Money.

Watch out for the Alternative Minimum Tax 

Many muni bonds are subject to the AMT. Fund buyers will invest in such bonds because they tend to offer slightly higher returns than non-AMT bonds. If AMT is a concern for you, look for muni funds that hold only bonds that avoid AMT liability. Check with your accountant before making your move.

Article Sources

  1. Financial Industry Regulatory Authority. "Municipal Bonds." Accessed Aug. 18, 2021.

  2. Fidelity. "Tax Implications of Bonds and Bond Funds." Accessed Aug. 18, 2021.

  3. "Municipal Bonds." Accessed Aug. 18, 2021.