Why Buy a Municipal Bond Fund?

Funding government investment offers a nice return and tax advantages

An investor looks over her muni bond fund performance.
•••

 Oscar Wong / Getty Images

The state you live in wants to undertake a major infrastructure project, or maybe your city needs to upgrade several public buildings like schools or its city hall. To raise money for these endeavors, the entity often will put a bond issue on the ballot and voters decide if the municipality or government can issue bonds for the project. 

As with stocks, you can buy municipal bonds individually or you can purchase a basket of them via a municipal bond fund. Learn more about municipal bond funds, how they function, and why you might want to buy one (or not). 

What Are Municipal Bond Funds?

Government entities, such as states, cities, and counties, often take on debt to fund ongoing operations or larger projects. We call the vehicle for this type of funding a “municipal bond.” 

If you purchase a municipal bond—“muni bond,” for short—you’re essentially lending the government money. In general, you’ll receive interest payments twice a year, alongside the return of your original, principal investment at the bond’s maturity. This time frame can range from a year to three years (short-term bonds) to more than a decade (long-term bonds). 

The government uses its taxing power or revenue generation to pay back with interest the bonds investors purchase. We call the former “general obligation” bonds and the latter “revenue” bonds. An example of a revenue-backed bond can be using highway tolls or express lane fees to return investor principal and interest.

Instead of investing in individual muni bonds, you can put your money in a municipal bond fund. A municipal bond fund is no different than a mutual fund that holds a basket of stocks across a benchmark, other than the fact that it holds bonds rather than stocks.

Some bond funds spread their exposure across different types of bonds, such as muni bonds, corporate bonds, or mortgage-backed securities. Others keep their assets in an exclusive category, such as municipal bonds. 

The largest fund families tend to have the biggest and highly-rated municipal bond funds. These include Fidelity Tax-Free Bond (FTBX), T. Rowe Price Tax-Free High-Yield (PRFHX), and Vanguard Short-Term Tax-Exempt Bond (VWSUX). All three muni bond funds carry a gold-star rating with Morningstar. 

As the names of the funds make clear, investors seeking tax advantages often buy municipal bond funds. Within the category, investors can seek out certain characteristics as, again, is the case with mutual funds. 

Pros and Cons of Investing in Municipal Bond Funds

Pros
  • Tax advantaged

  • Can offer a steady rate of return

Cons
  • Low yield

  • Non-recourse bonds

  • Credit risk

  • Call and interest-rate risk

Pros Explained

Tax advantaged: Generally, the interest you earn from your investment in a municipal bond or bond fund is exempt from federal taxes. If you live in the state where the bond was issued, you might also escape state and local taxes. As such, investors focused on a steady and reliable stream of income could look to municipal bond funds.

Can offer a steady rate of return: In general, municipal bond funds offer consistent returns over time. The returns may not be as high as more volatile investments like stocks, but they tend to outpace conservative products like CDs.

Cons Explained

Low yield: Muni bond funds tend to pay considerably lower yields (less interest) than other types of bond funds. While a muni yield, on its own, might be lower than other bond opportunities, the “after-tax yield” can be higher. You have to do the math (or maybe consult your financial and/or tax advisor) to see if a municipal bond fund’s tax-free status offsets the relatively lower yield. If you’re in a higher tax bracket, municipal bond funds might make particular sense to you because of your high long-term capital gains and net-investment-income tax rates. 

Certain bonds aren’t obligated to pay you back: Be sure to read the prospectus to get a handle on the investment approach of the municipal bond fund you’re looking at. Not all muni bonds are the same, so do your homework to ensure you know the specific type or types of bonds the fund you’re considering holds. 

For example, some revenue-backed bonds contain an out for the issuer. If the revenue stream the government intended to use to pay back the investor goes away (e.g., a drastic decrease in toll revenue during, say, a pandemic), the issuer is not obligated to pay you back.

Credit risk: Just as you scrutinize a country when trading its currency or company when buying its stock, consider the financial health of the state, city, or county issuing a municipal bond you’re looking at buying. With a fund, here again, scrutinize the prospectus and individual holdings to best understand investment style. 

Call and interest-rate risk: If the bond issuer repays its obligation before a bond’s maturity date (if the issuer “calls” or “redeems” it prematurely), you might not receive all the interest you expected. An entity might do this when interest rates drop below the interest rate the bond offers, thus saving money on interest payouts. Read up on the municipal bond funds you think you are interested in investing in to see if the bonds they own are callable or redeemable.

While relatively conservative investments, municipal bond funds do not come without risk. As Vanguard notes in its summary for VWSUX, in a rising interest rate environment, bond share prices tend to fall. An atmosphere of decreasing rates can put a drag on income.  

How to Buy Municipal Bond Funds

You can purchase municipal bond funds just as you would other investment vehicles— via your broker or a bank. You’ll buy shares of the bond fund just as you would a mutual fund that holds stocks. 

You can also buy shares of municipal bond ETFs. As with any other ETF, check on the fund’s fee structure.

One way to see how municipal bonds perform over time is to check an index that tracks them. Again, this is not all that different from assessing the Dow Jones or S&P 500. The S&P Municipal Bond Index is a good place to start. As of February 2021, the one-year return of this index stood at 3.40%. 

Key Takeaways

  • Government entities offer municipal bonds to fund infrastructure and other projects. You can buy individual municipal bond funds or purchase municipal bond funds that contain a collection of different muni bonds. 
  • While munis tend to offer lower yields than other types of bonds, you will generally not have to pay federal taxes (and, possibly state and local taxes) on them, making the after-tax return attractive, particularly for investors in a higher tax bracket. 
  • Municipal bond funds present less risk than other similar investments, but they’re not without risk. Interest rates impact bonds. Rising rates can hit a bond fund’s share price while decreasing rates can reduce yield, which is the income you can expect to generate from your investment.
  • You can purchase municipal bond funds or ETFs directly through your broker or bank, just as you do individual stocks, mutual funds, and stock ETFs.