Ask the Analyst: What Is the Best Source for Low-Risk Tax-Free Income?

In this Ask the Analyst series, I’m answering your questions about investing, personal finance, and retirement planning. Today’s question:

I’m 61, financially on track to retire at 70. Have been stashing cash for the past three years because I don’t want to take unnecessary risk and am already adequately invested. Now, taxes are an issue, so I did a ton of research to find good short-term and intermediate-term muni-bond funds. Dipped my toe in the bond fund pool with a short-term muni fund, and it’s down almost 2% already. No big deal, I’m in this for the long haul, but what are the best options for low-risk tax-free income? Thanks.

First of all, I commend you for planning ahead for your retirement. It’s a good idea to start derisking your portfolio at least five years before leaving the working world. Even though you’re still generating income and saving money for retirement, what happens during the years leading up to retirement can have a significant impact on how long your retirement savings can ultimately last.

Indeed, David Blanchett, Michael Finke, and Wade Pfau recently published research on the “retirement risk zone,” finding that the returns in the five-year period leading up to retirement can even matter more than returns immediately afterward. When you’re getting ready to retire, your portfolio is likely larger than it’s ever been, meaning that a bear market creates more damage in dollar terms. And with a shorter runway left until retirement, there might not be enough time left for the portfolio balance to fully recover before you start taking withdrawals.

Now, let’s talk about the losses you experienced. By definition, short- and intermediate-term municipal bond funds should be subject to less-extreme losses from rising interest rates than longer-term muni offerings. That’s because their underlying holdings have short- to intermediate-term durations (a measure of interest rate sensitivity). The muni-national intermediate Morningstar Category includes funds that invest in bonds with durations from 4.0 to 6.0 years, while the muni-national short category includes funds with durations of 4.0 years or less.

As you’ve experienced, though, these funds aren’t immune from losses. As shown in the graph below, intermediate-term muni funds have lost 5.4% over the past three months, on average, and short-term muni funds have lost 1.6%.

If you’re not comfortable with the type of losses you’ve experienced so far, there are a few short-term muni funds that have historically had lower risk profiles.

The table below highlights some funds with above-average Morningstar Medalist Ratings that have had below-average volatility and downside risk.

Muni target-maturity funds, which invest in bonds with a set maturity date and distribute cash back to investors at maturity, are another option if you’re looking for more reliable cash flows. These funds can also experience losses from rising interest rates, but they can be useful for investors who want to match the cash flows from their investments with a specific date—for example, to pay for a wedding, a child’s college education, or a down payment on a house. They could also be used to set up predictable cash flows to help cover costs during retirement. Invesco, iShares, Northern Trust, and State Street all offer low-cost versions of these types of funds.

Morningstar’s Role in Portfolio framework is a similar system for matching up your spending horizon with the duration or risk profile of your investments. With this approach, you would hold cash to cover expenses that you need to cover within the next 12 months, ultrashort bond funds for spending needs in the next one to two years, intermediate-term bond funds or lower-risk allocation funds for spending needs in the next several years, while reserving stock funds for assets that you don’t expect to need for at least 10 years.

Have a Question for Me?

In this monthly column, I answer questions from readers about investing, personal finance, and retirement planning. (Note: I’m focusing on questions that are of general interest to many of our readers, not personalized tax advice or portfolio recommendations.) You can submit one by filling out this quick survey.