High-Yield Municipal Bond Mutual Funds: Earn Tax-Free Income

The main appeal of bonds issued by state and local governments is that Uncle Sam doesn't tax the interest. But that break became less valuable to individual investors, banks and companies with the tax cuts Congress passed last year. A married couple with $200,000 in taxable income and filing jointly will have a 24% marginal tax rate in 2018, down from 28% in 2017. So a 3% tax-free muni yield now is worth the same as a taxable yield of 3.9% to that couple, down from 4.2% in 2017.

Earnings for All

• 35 Ways to Earn Up to 11% on Your Money
• Short-Term Accounts: 1%-2%
• Muncipal Bonds: 2%-3%
• Investment-Grade Bonds: 3%-4%
• Foreign Bonds: 3%-5%
• High-Yield bonds: 3%-6%
• Dividend-Paying Stocks: 4%-6%
• Real-Estate Investment Trusts: 4%-9%
• Closed-End Funds: 4%-9%
• Master Limited Partnerships: 8%-11%

The pressure of the tax cut and the rise in interest rates overall this year have pushed prices on muni bonds down and yields, which move in the opposite direction, higher. The yield on the Bloomberg index of triple-A-rated 10-year muni issues was 2.5% recently, up from 1.8% last September.

The risks: Despite some high-profile municipal bond defaults, such as the 1994 default by California's Orange County, the vast majority of state and local bond issuers repay their debts as promised. But the number of muni issuers facing financial woes is likely to increase, says Matt Fabian, a partner at research firm Municipal Market Analytics. Slow economic growth in many parts of the U.S. could crimp tax revenue–at the same time that state and local governments are spending more for Medicaid, public pensions and infrastructure. That means "muni investors should focus on better-quality bonds," Fabian says.

How to invest: Many financial advisers still favor muni bonds as a core fixed-income holding for their wealthiest clients, especially in high-tax states such as California and New York. That's because in addition to the federal tax exemption, you typically get a state tax exemption on bonds issued in the state where you live, notes Dale Yahnke, of financial advisory firm Dowling & Yahnke. As a first step, see if muni yields are a better deal than taxable bond yields in your federal and state tax brackets. Then decide how much volatility you can take. If you're investing via mutual funds, weigh yield against duration risk.

Among funds that invest in munis nationwide, Fidelity Intermediate Municipal Income (FLTMX, 2.2%) has a track record of providing decent yields with below-average expenses and below-average volatility. It's a member of the Kiplinger 25, the list of our favorite no-load mutual funds. The fund has a duration of 4.9. Investors who want to focus on high-quality munis might consider SPDR Nuveen Bloomberg Barclays Municipal (TFI, $48, 2.5%). The exchange-traded fund, with a duration of 7.0, is designed to track the Bloomberg Barclays Muni Managed Money index. It owns mostly bonds rated double-A or better. Because it's an index fund, the portfolio is skewed toward large debt issuers, such as California and New York, which are weighted more heavily in the index. Another index fund worth a look is Vanguard Tax-Exempt Bond Fund ETF (VTEB, $51, 2.5%). About 75% of its bonds are rated double-A or better. The fund, launched in 2015, has a duration of 5.7 and an annual management fee of just 0.09% of assets–lower than all of its peer funds.