How to Find Bargains in Municipal Bond Funds
Tax-exempt bonds have become much cheaper. Here’s a guide to finding the best deals.
Prices up, prices down. The bond crash did not spare municipal bond funds. In the first half of the year, they managed to lose up to 30% of their investors’ money.
Look on the bright side. If you are one of the losers, take a capital loss and immediately reinvest in a similar (but not identical) fund. If you’re new to tax-exempt investing, relish the fact that you’ll get a much better deal now than just a few months ago.
For this guide, I’ve chosen three different types of municipal funds (mutual, exchange-traded, and closed-end) to find bargains. Here, “good” means having an annual net cost of no more than 0.2%, or $200 per year per $100,000 invested.
Twenty-eight funds made the cut. Among mutual funds (aka “open-end”), the only ones worth your attention are those from Fidelity and Vanguard. With ETFs, seven providers are eligible. The list of profitable closed-end funds is very short: two products, both from Nuveen.
Who should hold tax-exempt bonds? An investor in a somewhat high tax bracket who needs a somewhat conservative investment.
I’ll define a tax bracket as somewhat high if it’s at least 24%, which is about $200,000 or more in adjusted gross income on a joint return. If you’re in a lower bracket, you should probably stick to taxable bonds. With munis, you would be competing with wealthy buyers who are more eager for tax breaks.
As for tax-exempt bonds which are only somewhat conservative, you can see from the numbers in the tables below that it is possible to lose money. You can reduce risk by aiming for shorter durations and avoiding anything with the words “high yield” in the name. Duration is a measure of how long it takes for a purchase price to be recovered in coupon and principal payments.
Taxable bonds generally, but not always, must be placed in a tax-deferred account. Munis should never go into a tax-deferred account.
What about individual bonds, as opposed to a bond fund? Your stockbroker can promote this idea. The broker is not going to like my take. I think individual munis only make sense if you invest at least $100 million. Reason: You need a large sum to get good diversification and a good price.
Don’t think you can stand out by picking only the right issues. Do you have time to read 3,000 bond deeds? Let Vanguard do the analysis. He can put $100,000 to work for an annual fee of $50.
Even after the bond crash, returns are meager (3% to 4% on high-quality munis), so it would be a shame to pay a penny more than necessary to have the portfolio managed. Here are the cheapest funds. Click on a column header to sort.
For a tax-exempt mutual fund with no fees, look no further than Fidelity Investments and Vanguard Group. Fidelity has a low cost offer. Vanguard has nationally diversified portfolios with a range of duration choices, as well as a handful of single-state options.
If your state is not listed here, buy a national fund and pay local tax on your interest income. Don’t get sucked into an expensive one-time state fund in a blind race for state tax cuts.
Do the math. If munis earn 3% and your state’s tax bracket is 8%, all you can save by taking double tax exemption is 0.24%. Therefore, the maximum you should be willing to pay for a single state fund is that amount plus the 0.05% you would pay for the best buy in the national portfolios. Total, 0.29%. Single state funds not from Vanguard tend to cost significantly more than that.
Expense ratios shown on Vanguard funds are for the Admiral share class, with a minimum investment of $50,000 in most cases. If you’re investing less than $50,000, you probably shouldn’t worry about munis at all.
As you move from the traditional mutual fund to the new exchange-traded format, you see more and more providers that can compete with Vanguard in terms of profitability.
This list includes some intriguing products from Invesco and BlackRock (labeled “chip” or “term”) that end in different years. These things can be useful if you know you want your money back on a certain date in the future. But at 0.18% per year, they are at the expensive end of the tolerable range for an endowed fund.
This year has delivered a triple whammy to investors unhappy with shares in closed-end funds, the kind with a fixed number of shares. These stocks are bought and sold secondhand, often at a price lower than the value of their portfolio.
First, portfolio values have been impacted by rising interest rates. Second, many of these funds use borrowed money to buy municipal bonds, accentuating losses in the bear market. And finally, the discounts have widened.
Big discounts attract the attention of value hunters. Are some of these tax-exempt bond funds now good buys?
I rummaged through 114 closed munis, looking for bargains. I came empty-handed. Only two of this entire group have ownership costs that can be described as tolerable (0.2% per year or less), and neither is a great buy.
Yes, discounts are nice, but they don’t create the bargain you think they do. Suppose you find a closed trade with a 10% discount. This means you can buy $100 worth of bonds for just $90.
When you go to sell, that discount may have shrunk (giving you a bargain) or widened (a misfortune). A neutral expectation is that the discount does not move. In other words, your expected capital gain from the discount is zero.
The discount helps with dividends. Suppose the fund pays you a dividend of $4. You paid only $3.60 for this silver coin. So you have a 40 cent bonus.
You’re not going to get rich on these dividend bonuses, especially if the fund’s annual overhead is over 40 cents per $100. Almost all closed-end municipal funds have expense ratios above 0.4%.
To value closed stocks, I considered dividends, discounts and expense ratios. I’ve also credited leveraged funds for managing over $100 of bonds for every $100 of your net asset value. And still the closed ends look pretty awful.
Both with tolerable cost burden are Nuveen Select Tax Free Income (ticker: NXP; effective cost of ownership 0.09% per year) and Nuveen New York Select Tax Free (NXN, 0.13%).
For the rest, wait for discount discounts to double or triple from their current level.