Home > Articles > Business & Management > Finance & Investing

  • Print
  • + Share This
This chapter is from the book

Municipal Bonds—Don't Share with the Tax Collector

So far we have talked about bonds issued by the federal government and by companies looking to borrow money. State and local governments, as well as separate agencies that they sponsor, also need to borrow money from time to time. The big attraction to buying bonds issued by state or local governments, called municipal bonds, is that the interest they pay is generally not subject to federal income tax.9 Moreover, if your home state has a state income tax and you buy bonds issued by a government entity within your state, you will probably escape state income taxes as well.

This can be very beneficial to investors in high tax states who are in the top tax brackets. For example, if your combined state and federal tax burden is 40%, a taxable bond paying 6% will generate only 3.6% interest for your benefit after you pay the taxes due. If you could get 4% tax-free from a municipal bond, then that would be a better deal for you, all else being equal. As a general rule, on an after-tax basis, municipal bonds tend to pay more than taxable bonds for high-bracket investors. If you are in a relatively low tax bracket, as many retirees are, then municipal bonds may not be for you. You should calculate the after-tax yields (using yield to maturity) from the different bond investments available to you before you commit to municipal bonds.

Unlike the U.S. Treasury, state and local governments cannot print money to pay their debts. As a result, just like corporate bonds, municipal bonds have credit risk and they generally carry credit ratings. Municipalities can buy insurance for their bonds. Insured municipal bonds carry the highest credit rating, implying low risk. However, in theory, insured municipal bonds are only as safe as the insurance company that guarantees them, which is good but not perfect.

There are a number of mutual funds that invest in municipal bonds. Although they afford excellent portfolio diversification and liquidity, their expenses are usually a big drawback. To see why this is an especially severe problem for municipal bond investors, let's return to the example of a taxable bond portfolio paying 6%/year in interest (yield to maturity) and a municipal bond portfolio paying 4%/year. Recall that an investor in a 40% tax bracket would fare better with the 4% tax-exempt bond portfolio.

However, if these portfolios are held by mutual funds with 1% expense ratios, then the yields generated for investors are reduced by 1% in both cases, down to 5% for the taxable bond portfolio and 3% for the municipal bond portfolio. The mutual fund's expenses represent, in effect, a tax of 1/6 of the taxable bond yield (1% out of 6%), but a higher effective tax of ¼ of the tax-exempt bond yield (1% out of 4%). Net of the mutual fund's fee, the returnsof the municipal bond fund are no longer better than the returns of the taxable bond fund on an after-tax basis. For this reason, we recommend that you utilize only the least expensive tax-exempt mutual funds—those with expenses of 0.3%/year or less. That pretty much limits you to offerings from Vanguard, or to the Fidelity Tax-Free Bond Fund (FTABX). Table 7.3 lists selected offerings from Vanguard that we have found useful in the past. Under current bond market conditions, the tax-exempt money market is the best bet because it pays the same yield as the other bond funds, but does not expose you to any interest rate risk. In addition to the funds listed in Table 7.3, Vanguard offers a number of funds holding bonds from single states that are designed specifically for residents of those states.

Table 7.3. Selected Tax-Exempt Bond Funds from Vanguard

Vanguard Fund

Ticker Symbol



Tax-Exempt Money Market




Short-Term Tax Exempt




Intermediate-Term Tax Exempt




There is one exceptional municipal bond fund that we have used successfully for our money management clients over the years: The Nuveen High Yield Municipal Bond Fund (NHMAX). Even though its expenses are 0.88%/year, its performance net of expenses has been better than the low-expense offerings from Vanguard and far better than the average tax-exempt bond mutual fund since its inception in 1999. You should only purchase NHMAX without paying a sales charge to a full-price broker. The fund is available through discount brokerages such as Schwab and T.D. Ameritrade.

An alternative to tax-exempt bond mutual funds is to buy individual municipal bonds, for which you need to go through a broker. The process is murkier when you use a broker to buy bonds than it is with stocks because with bonds, there is no explicit commission. Rather, the price of the bond you are buying is marked up from the dealer's cost. Typically, the mark-up is 1–2% of the amount you are investing. If you buy a portfolio of individual bonds with an average maturity of 10 years, and you pay the dealer a mark-up of 2% in doing so, then you have effectively incurred an expense of 0.2%/year. This is less than what the vast majority of bond mutual funds charge. Although the Vanguard funds listed in Table 7.3 have lower expense ratios than 0.2%/year, the funds too must bear the impact of paying a mark-up to whomever sells bonds to them. (Presumably as large buyers, they should be getting a better price for their bonds than an individual investor could.) You should not take the 2% one-time cost for granted, however. At times, unwary customers have been known to pay mark-ups as high as 5%.11

The usual minimum amount you can invest in any single bond is $10,000 without paying a very high mark-up, so in order to diversify among several different bond issues, you would need a relatively sizeable portfolio (at least $50,000) compared to the $3,000 minimum investment required to get into the mutual funds listed in Table 7.3. You should also purchase only individual bonds that you are highly confident of holding until maturity, because selling bonds back to a dealer is like trading in a used car: In order for the dealer to make his profit, he has to pay you something below the true market price.

Here are some tips for investing in individual municipal bonds:

  1. Ask the prospective broker for his proposed portfolio, its average maturity, its average credit rating, its duration, and its yield to maturity. Compare that to the similar portfolio characteristics for one of the bond funds listed in Table 7.3, which are available online at www.vanguard.com.
  2. Be sure to specify when placing an order through a broker that you want to pay the minimum that his firm allows. (Brokers have a certain amount of discretion to lower the prices from their initial quote; for example, the price they might quote on a firm website.)
  3. Sometimes bond dealers have what are called odd lots to sell. Normally, a broker wants to transact in round lots, which are multiples of 10 bonds. If in their inventory they have a smaller amount (say $5,000) of a particular issue, they might be willing to let it go at a lower price just to save themselves the trouble of keeping records on what for them is a very small investment.

For most individual investors, one of the recommended municipal bond mutual funds is likely the best way to go. However, issues for you to consider with regard to your own situation in choosing the best way for you to invest in bonds are listed in Table 7.4.

Table 7.4. Pros and Cons of Owning Individual Municipal Bonds Versus Municipal Bond Mutual Funds

Factors That Favor Using a Broker to Buy Individual Bonds

Factors That Favor Using Bond Mutual Funds

If you want a customized portfolio. (For example, if you live in a state for which an economical single-state municipal bond fund is not available.)

If one of the recommended bond mutual funds meets your needs.

If you want to know the exact income stream from your bond investments at the time you make them.

If there is a significant chance that you might want to cash out some or all of your bond investments before maturity.

If you are concerned about the possibility of an alternative minimum tax liability. (Some interest paid by muni bond funds is subject to the alternative minimum tax. If you select individual bonds, you can avoid that pitfall.)

If you have under $50,000 to invest in municipal bonds.

If there is no low-expense municipal bond mutual funds that meet your needs, and you have a broker you trust.

Different Types of Bond Investments to Suit Your Style

All bond investments are based on the basic principles we have covered so far. To review:

  1. Bonds are loans that pay you, the lender (bondholder), interest during the term of the loan. At maturity, you receive the original face value of $1,000 per bond.
  2. Changes in interest rates cause the values of existing bonds to change. A fall in interest rates increases the values of existing bonds. A rise in interest rates decreases the values of existing bonds.
  3. A bond's credit rating is the assessment of a rating agency of its level of confidence that the borrower will be able to meet its obligations to pay interest and return principal to bondholders. Investment-grade bonds have relatively high credit ratings and a very low risk of defaulting. High yield bonds have below investment grade credit ratings, have a potentially significant risk of defaulting, and for this reason must pay higher rates of interest to investors.
  • + Share This
  • 🔖 Save To Your Account

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information

To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.


Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.


If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information

Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.


This site is not directed to children under the age of 13.


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information

If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information

Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents

California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure

Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact

Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice

We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020