Municipal bonds are issued by local city and county governments to raise money. They may fund libraries, schools, highway improvements, or sports stadiums.
Some municipal bonds are general obligation (GO) bonds. This means that the issuing government is free to use the money as it sees fit, whether to buy a new police cars or pay janitors at the county hospital.
Other municipal bonds can be used only for a specific purpose. For instance a county could use the funds to build a toll road. The tolls collected from motorists is used to repay bond owners.
Some consider GO bonds safer because the government can pay the required interest out of any money collected, whether taxes or speeding ticket fines. Some consider the other bonds safer. That’s because a municipality’s toll booth may continue to make money even as its property tax base goes downhill.
Historically, municipal bonds have low rates of default. The few cases of prominent muni bond defaults made big news. But the 1983 Washington Public Power Supply System default on bonds used to finance nuclear power plants and the 1994 Orange County California bankruptcy remain exceptions.
The big appeal of municipal bonds is that their interest is tax-free at the federal level. However, because of this feature municipal bonds pay interest rates that on average are lower than corporate bonds.
Therefore many wealthy investors with a high marginal tax rate put all their money into muni bonds to reduce their federal tax burden. Municipal bonds are not as advantageous for investors in lower tax brackets.
They also are not the best investment for tax-sheltered accounts such as conventional or Roth IRAs. That’s because accumulating tax-free income inside a retirement account is a waste of its tax-shelter status.
Interest income from municipal bonds is taxable by cities and states.
There are many thousands of muni bonds to choose from, and they are not easy or convenient to buy even for the wealthy. Bond brokers generally service institutions with millions of dollars to spend.
However, investors can buy shares of the iShares S&P National AMT-Free Municipal Bond Fund: MUB and SPDR Barclay’s Capital Municipal Bond ETF: TFI.
MUB tracks the S&P National AMT-Free Municipal Bond Index.
TFI tracks the Barclay’s Capital Municipal Managed Money Index (ticker: LMMITR).
(AMT stands for Alternative Minimum Tax. So the income from both these ETFs is not taxable by the IRS.)
MUB’s expense ratio is 0.25%. TFI’s is 0.30%.
MUB’s total holdings is 592. TFI’s is 282.
MUB’s average credit rating is AA-. TFI’s is AA2.
Both funds pay dividends monthly.
MUB’s average maturity is 7.93 years. TFI’s is 7.70.
TFI has a slightly higher expense ratio. It also has just half as many holdings, so it’s not as diversified as MUB. Otherwise they have similar characteristics, so it’s not necessary to buy both.
Investors in the highest tax brackets who want to diversify their municipal bond portfolios while receiving monthly checks should consider investing in either MUB or TFI.