Do Municipal Bonds Have a Place in My Portfolio?

Question: I know that municipal bonds offer great tax breaks for investors, but I'm not sure they make sense for my portfolio because I'm not in the highest tax bracket. Am I better off investing in municipal bonds or traditional bond funds? How would I know?

Answer: Late 2010 and the beginning of 2011 were marked by some scary (and exaggerated) headlines on the state of municipalities' finances, laying the groundwork for a terrific buying opportunity in the asset class. The average muni fund has gained 13% in the one-year period through January, prompting Morningstar director of fixed-income analysis Miriam Sjoblom to opine in a recent video that last year's returns may not be easily repeated.

But as much as it's a mistake for investors to performance-chase, they shouldn't necessarily dismiss munis out of hand. Once tax effects are factored in, muni-bond-fund yields may well be higher than yields from comparable taxable funds, and that's especially likely to be true for investors in higher income tax brackets.  

Calculate the Benefits: Taxable-Equivalent Yield
Unlike most taxable bonds, income generated by municipal bonds is exempt from federal and sometimes state and/or local income taxes. That tax break is why municipal bonds will often feature yields that are a few percentage points lower than those of their taxable counterparts. So when comparing a municipal bond's yield to a taxable alternative, you should take the muni's embedded tax advantage into account. To that end, calculating taxable-equivalent yield can help investors compare taxable and municipal-bond funds. In other words, the taxable-equivalent yield helps investors perform an apples-to-apples comparison by adjusting municipal-bond fund yields to a tax-equivalent level.

Morningstar.com offers a tax-equivalent yield function on its Bond Calculator that helps investors determine whether they're better off investing in taxable or municipal bonds based on their federal and state tax rates. (Click here to find your state tax rate, and here for more details regarding your federal tax rate.)

For example, let's say you're an investor who's in the 28% federal tax bracket who resides in Illinois, which has a flat state income tax rate of 5%. If you wanted to compare the amount of income generated from  Vanguard Intermediate-Term Investment-Grade Investor (VFICX) and  Vanguard Intermediate-Term Tax-Exempt Investment (VWITX), both of which land in the same square of the Morningstar Style Box, you'd start by finding the yield for both offerings. The quote page for each fund shows that Vanguard Intermediate-Term Investment-Grade Investor has a 4.12% trailing-12-month yield, while Vanguard Intermediate-Term Tax-Exempt has a 3.41% yield over the trailing 12 months. With all this information, you can now input the appropriate data into the tax-equivalent bond calculator. (Note that because of the recent rally, especially in munis, these funds' current yields are lower than their trailing-12-month yields--1.83% for the muni fund and 2.88% for the taxable fund. For the most current information on a fund's yield, look for its SEC yield, usually available on fund companies' websites.)

When using the calculator, first enter the municipal bond's attributes and whether its income is exempt from state and local taxes. (If it's a muni-national fund, such as Vanguard Intermediate-Term Tax-Exempt Investment, you'd click on the "no" radio button; muni income is typically only exempt from state taxes if the shareholder lives in the same state that issues the debt. Muni-national fund investors give up most of that state tax break, but they benefit because the funds are geographically diversified.)

Next, fill in the attributes for the taxable-bond fund. In the case of Vanguard Intermediate-Term Investment-Grade Investor, it is diversified across bond sectors, so respond "no" to the question of whether it's a Treasury bond. Finally, select your federal tax bracket from the dropdown menu and enter in your state tax rate.

Assuming a federal tax rate of 28% and a state tax rate of 5%, you can then see how the yields compare. When you hit the Calculate button, you'll see the yield for the taxable fund (4.12%) alongside the tax-equivalent yield for the muni-bond fund (4.74%). This means that based on its 12-month yield information, the muni-bond fund has a higher yield, once your tax rates are factored in, than the taxable fund. (Using SEC yield rather than 12-month yield gives the edge to the taxable fund.)

Mind These Risks
Although yield is important when considering bond funds, don't shop on yield alone, because an investment's yield will generally be correlated with its risk level. As with equity funds, also consider the muni-bond fund's track record (including bear-market years like 2008), costs, manager tenure, and strategy. Keep an eye on the fund's duration; as with all bond funds, it's a good measure of how much interest-rate risk a muni-bond fund bears. Typically, a longer duration means a greater potential for gains and losses. Credit quality should be a central consideration given that some funds might be taking on significant credit risk depending on their exposure to certain municipalities.

Regarding both duration and credit quality, Morningstar recommends taking a more measured approach by sticking to intermediate-term munis with average credit qualities of AA, which usually means that the fund has a big enough stake in high-quality bonds to cushion against credit risk but is also parked in some lower-rated issues to exploit their higher yields.

A version of this article appeared Nov. 16, 2011.