How To Find Bargains In Municipal Bond Funds

Tax-exempt bonds have gotten a lot cheaper. Here’s a guide to finding the best deals.

Rates up, prices down. The bond market crash has not spared municipal-bond funds. In the first half of the year they have managed to lose as much as 30% of their investors’ money.

Look on the bright side. If you’re one of the losers, take a capital loss and immediately reinvest in a similar (but not identical) fund. If you are new to tax-exempt investing, relish the fact that you’ll get a much better deal now than you would have just a few months ago.

For this guide I picked through three different kinds of muni funds—mutual, exchange-traded and closed-end—looking for good deals. Here, “good” means having an annual net cost no higher than 0.2%, or $200 a year per $100,000 invested.

Twenty-eight funds made the cut. Among mutual (a.k.a. “open-end”) funds, the only ones worth your attention are from Fidelity and Vanguard. With ETFs, seven providers qualify. The list of cost-effective closed-end muni funds is very short: two products, both from Nuveen.

Who should own 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%, corresponding to roughly $200,000 or more of adjusted gross income on a joint return. If you’re in a lower bracket you should probably stick to taxable bonds. With munis you’d be competing with rich buyers who are more avid for the tax break.

As for tax-exempt bonds being only somewhat conservative, you can see from the numbers in the tables below that it’s possible to lose money. You can lessen the 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 recouped in coupon and principal payments.

Taxable bonds should usually, but not always, go in a tax-deferred account. Munis should never go in a tax-deferred account.

What about individual bonds, as opposed to a bond fund? Your stockbroker may be promoting that idea. The broker is not going to like my take. I think individual munis make sense only if you are investing at least $100 million. Reason: You need a large sum in order to get good diversification and good pricing.

Don’t think you can come out ahead by selecting just the right issues. Do you have time to read 3,000 bond indentures? Let Vanguard do the analyzing. It can put $100,000 to work for an annual fee of $50.

Even after the bond crash, yields are meager (3% to 4% on high-quality munis), so it would be a shame to pay a penny more than you have to to get the portfolio managed. Here are the lowest-cost funds. Click on a column head to sort.

Mutual funds

For a no-load tax-exempt mutual fund, look no further than Fidelity Investments and Vanguard Group. Fidelity has one low-cost offering. Vanguard has nationally diversified portfolios with a range of duration choices, plus a handful of single-state options.

If your state isn’t listed here, buy a national fund and pay local tax on your interest income. Don’t be suckered into an expensive single-state fund in a blind rush for a break on state taxes.

Do the arithmetic. If munis are yielding 3%, and if your state tax bracket is 8%, then all you can save by going double-tax-free is 0.24%. Therefore, the most you should be willing to pay for a single-state fund is that much plus the 0.05% you’d pay for the best buy in national portfolios. Total, 0.29%. The single-state funds not coming from Vanguard tend to cost a whole lot more than that.

The expense ratios shown on the Vanguard funds are for the Admiral share class, with a $50,000 minimum investment in most cases. If you’re investing less than $50,000 you probably shouldn’t bother with munis at all.

ETFs

As you move on from the classic mutual fund to the newer exchange-traded format, you see more vendors capable of competing with Vanguard in cost efficiency.

This list includes some intriguing products from Invesco and BlackRock (labeled “bullet” or “term”) that terminate in different years. These things may be useful if you know you want your money back at a certain future date. But at 0.18% a year, they are at the expensive end of the tolerable range for a muni fund.

Closed-ends

This year has delivered a triple whammy to the unfortunate investors with shares in closed-end funds, the kind with a fixed number of shares. Those shares are bought and sold second-hand, often at a discount to their portfolio value.

First, the portfolio values got hammered by the rise in interest rates. Next, many of these funds use borrowed money to acquire municipal bonds, accentuating losses in the bear market. And finally, discounts widened.

Fat discounts catch the eye of value hunters. Are some of these tax-exempt bond funds now good buys?

I pawed through 114 muni closed-ends, looking for bargains. I came up empty-handed. Only two out of that entire group have ownership costs that can be called tolerable (0.2% a year or less), and neither is a great buy.

Yes, discounts are nice, but they do not create the bonanza you think they do. Suppose you find a closed-end trading at a 10% discount. That means you can acquire $100 of bonds for only $90.

When you go to sell, that discount might have narrowed (giving you a windfall) or widened (a misfortune). A neutral expectation is that the discount doesn’t budge. That is, your expected capital gain from the discount is zero.

The discount does help with dividends. Suppose the fund pays you a $4 dividend. You paid only $3.60 for that piece of cash. So you have a 40-cent bonus.

You’re not going to get rich off those dividend bonuses, especially not if the annual overhead on the fund comes to more than 40 cents per $100. Almost all of the closed-end muni funds have expense ratios above 0.4%.

To evaluate the closed-ends I took into account dividends, discounts and expense ratios. I also credited the leveraged funds for handling more than $100 of bonds for every $100 of your net asset value. And still the closed-ends look pretty awful.

The two with a tolerable cost burden are Nuveen Select Tax-Free Income (ticker: NXP; effective ownership cost of 0.09% a year) and Nuveen New York Select Tax-Free (NXN, 0.13%).

As for the rest, wait for discounts to discounts to double or triple from where they are now.