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A Checklist for Muni Bond Investors

Six considerations for those considering an investment in municipal bonds.

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Note: This article is part of Morningstar's November 2015 Income Investing Week special report. This article originally appeared July 28, 2015. 

At first blush, municipal bonds may not seem like the most exciting investment--essentially, they are bonds issued by state and local governments to finance public projects such as buildings and roads. But here's where they become interesting: These types of bonds provide tax advantages that can be especially beneficial to investors in higher tax brackets. In the vast majority of cases, the income they provide is not taxed at the federal level. In some instances (particularly if issued by a state or municipality in which you reside), munis' income is not taxed at the state or local level, either. (This is a big consideration if you live in a high-income-tax state, such as California, New York, or New Jersey.)

Though munis traditionally have lower yields than similarly dated taxable bonds, because of their tax advantages, their yields often compare favorably with those of taxable investments once the munis' tax benefits are factored in. But right now munis' pretax yields are close to those of taxable bonds, making munis especially attractive on an aftertax basis. 

Finally, their tax-advantaged income status means that investors can hold them in taxable accounts, which can offer greater flexibility than tax-sheltered accounts. (See Morningstar director of personal finance Christine Benz's article on "6 Key Reasons Why Investing in a Taxable Account Is Underrated".)

Here are the key factors that investors should consider when deciding whether to include municipal bond funds in their portfolios, as well as what type of muni exposure makes the most sense.

Credit Quality Considerations
Like other bonds, municipal bonds have certain risks associated with them. A bond's primary risk is that the issuer could default. If a creditor defaults on its bond obligations, it means the entity that issued the bond does not have the willingness or ability to make timely payments of interest and principal. This risk has become increasingly in focus recently, as credit woes in Puerto Rico, Detroit, and most recently Chicago have grabbed headlines. 

Yet Morningstar senior analyst Beth Foos argues that the muni market is quite healthy overall. "Overall the credit quality of the muni market is still strong, although those scary headlines are increasing. Although there may be some pockets of concern, the municipal bond market is more than $3.7 trillion overall and the default rate historically has been extremely low, and we expect it to remain so," said Foos.

Interest-Rate Sensitivity
Another risk facing muni-bond investors is interest-rate risk. This risk is not specific to muni bonds; municipal and taxable bonds alike are sensitive to interest-rate movements. Put simply, bond prices have an inverse relationship with interest rates, so rising interest rates can cause bond prices to fall. As a result, in a rising-rate environment longer-dated muni bonds will bear the brunt of the sell-off more intensely than shorter-term munis. 

Your Time Horizon/Risk Capacity
Muni bond funds are offered in many of the same flavors as funds composed of more traditional bonds. The right type of fund depends on an investor's time horizon and risk capacity. For instance, an investor can find long-, intermediate- and short-dated muni funds; it’s sensible to match the fund’s time horizon to your own. Investors who have more short-term investment goals or those who expect rates to rise would be better off choosing a short- or intermediate-term muni bond fund. 

Your time horizon and risk capacity can also help inform how much credit risk you want in your muni-bond fund. "Because most investors seeking muni-bond exposure are looking for some income without a lot of volatility, higher-quality funds will make sense in most instances," said Christine Benz. As their name implies, high-yield muni funds tend to have higher yields but their risk of default is higher, because they invest in issues with lower credit ratings. It's also worth noting, however, that some municipal bond funds that are not in the high-yield muni category delve into lower-quality bonds, too. It's always wise to scrutinize credit quality ratings and read Morningstar analyst reports closely to learn about other risk factors. 

Within each category, funds' performance is driven by factors including changes in bond yields, municipal credit events, the size of the muni bond new issue calendar, and other technical factors such as fund flows. Headline risk can also move the market, as seen in fund outflows in 2011 following Meredith Whitney's doomsday prediction about the muni market (which in hindsight provided a good buying opportunity for muni investors), and more recent coverage of the financial troubles of Chicago and Puerto Rico. 

Your Tax Position
As mentioned earlier, adding municipal-bond exposure can be particularly advantageous if you are in a high tax bracket. But even if you're not in the highest tax bracket, it can still make sense. 

Let's compare the amount of income generated from  Vanguard Interm-Term Treasury Inv (VFITX) (a Silver-rated fund in the intermediate government category) and  Vanguard Interm-Term Tax-Exempt Inv (VWITX) (a Silver-rated fund in the intermediate muni-national category). The Quote page for each fund shows that Vanguard Intermediate-Term Treasury has a 1.55% SEC yield Vanguard Intermediate-Term Tax-Exempt has an SEC yield of 1.85%. 

Plugging those values into our Tax-Equivalent Yield Bond calculator, the tax-advantaged yield on the muni-bond fund is equivalent to a 2.5% aftertax yield assuming an investor is in the 28% tax bracket. (Note that even without the tax benefits factored in, the muni-bond fund's yield looks attractive across all tax brackets due to Treasuries' somewhat-anomalously low current yields; this will not always be the case, however.) But for investors in the highest tax brackets, the muni-bond fund's yield, once taxes are taken into account, also looks attractive compared with  Vanguard Interm-Term Invmt-Grade Inv (VFICX) (a Silver-rated fund in the corporate-bond category), which has an SEC yield of 2.73%. 

Bonds vs. Bond Funds
Another question some investors might have is whether it makes sense to buy individual municipal bonds versus muni-bond funds. After all, when buying individual bonds it's possible to sidestep the interest-rate risk issue of holding a basket of muni bonds; provided you buy a bond that does not default and hold until maturity, you will receive your interest and principal regardless of interest-rate fluctuations. With a bond fund, by contrast, the value of your investment and even the fund's yield can fluctuate, for better or for worse. But it's unwise to derive a false sense of security from investing in individual bonds, says Christine Benz in her article "Don't Overlook the Risks of Individual Bonds". Even though holding a bond to maturity can offer some protection from interest-rate hikes, individual-bond buyers are giving something else up: the flexibility to swap into higher-yielding bonds as they become available. (For more on this, see Eric Jacobson's video "Should You Consider Individual Bonds?")

Additionally, conducting due diligence on individual bonds requires investors to get under the hood of an issuer's credit risk and the individual bond's risk of default, which can be especially challenging when researching municipal issuers. Also, high trading costs can mean that it only makes sense to invest in big blocks of individual bonds, but for individual investors, that can then lead to a lack of diversification (this would be especially costly in the case that the bond’s issuer defaults). 

Paying attention to expenses is always important when shopping for mutual funds, because expenses directly impact the return an investor can expect to receive. As Morningstar director of fund research Russ Kinnel wrote in his article "Lower Your Fees, Boost Your Return", funds in all asset classes that charge less are naturally more likely to outperform than those with high costs. 

Price is an even more important consideration with bond funds than some other fund types, such as equity funds, because bond funds' range of expected returns tends to be more limited. Municipal bond funds with higher expense ratios to clear find themselves at a return disadvantage. To overcome this hurdle, more-expensive funds may invest in riskier issues to try to juice their return. Be sure you're not paying a higher price to take on more risk. 

Consult Analyst Ratings
Morningstar Analyst Ratings are handy guides for monitoring existing holdings and finding new investments. Funds that earn Analyst Ratings of Gold, Silver, or Bronze (also known as Morningstar Medalists) are expected to outperform their categories and their benchmarks over a full market cycle. 

When assigning ratings, Morningstar analysts concentrate on the drivers that give funds long-term competitive advantages, such as repeatable and consistent investment processes, deep manager and analyst teams, and low expenses.

Premium Members can access a list of medalist funds in the municipal bond category by clicking  here. As of this writing, 32 funds earn medals across the muni national long, muni national intermediate, muni national short, and high-yield muni categories. In addition, seven funds investing in single-state municipal bonds earned medals--four that focus on California and three that focus on New York.

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Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.