Investors Found A Tax Break That Pays Big Yields, Too

Talk about a squeeze: Taxes are going up and yields remains low. But some investors think they’ve found a tax break in this financial pickle: municipal bond ETFs.


Investors poured more than $16.4 billion into Federal tax-free municipal bond ETFs so far this year, says Todd Rosenbluth, head of mutual fund and ETF research at CFRA. That’s 12% more than investors put into these ETFs in all of 2020. Muni bond ETFs grabbed 11 cents of every dollar flowing into bond ETFs, while they’re just 6.8% of the asset universe.

What’s the draw? It’s simple: most municipal bonds pay interest exempt from Federal income taxes. And some even skip out of state and local taxes, too. That’s a huge edge already. And it could be even more valuable if tax rates head higher to pay for generous government spending programs.

“Municipal bond mutual funds remain popular; investors are increasingly looking to ETFs for tax-free income,” Rosenbluth said.

Looking At The Muni Bond ETF Tax Break

Some math shows the tax break draw of muni bond ETFs — even now.

The top 20 largest municipal bond ETFs yield an average 1.95%, says data from Morningstar Direct and S&P Global Market Intelligence. That may not sound that great. But it translates into an average tax-adjusted yield of 2.56% if you’re in a 24% tax bracket. That’s not a huge yield, either, but still tops the 2.17% yield of the $82 billion-in-assets Vanguard Total Bond Market ETF (BND), which is taxable.

And the tax benefits impressively rise if you’re in a higher bracket, or think tax rates are going up. The tax equivalent yield of the 20 largest muni bond ETFs jumps to an impressive 2.99% if you’re in the 35% tax bracket.

Choosing A Muni Bond ETF

How do you choose the right ETF for you? Two muni bond ETFs are giants in the industry and suit the needs of most people. The nearly $24 billion-in-assets iShares National Muni Bond ETF (MUB) is the largest. And it’s followed by the Vanguard Tax-Exempt Bond ETF (VTEB) with assets of $14.1 billion.

These two ETFs take similar approaches and yield roughly the same, Rosenbluth says. The 12-month yield on iShares National Muni is 1.88% vs. 1.73% for Vanguard Tax-Exempt. They also cost about the same, 0.07% and 0.06%, respectively.

The holdings, too, are comparable. Just 7.6% of Vanguard Tax-Exempt’s holdings carry the lowest-possible BBB rating, Rosenbluth says. Similarly, only 5.6% of iShares National Muni are rated BBB. Additionally, both ETFs put roughly three-quarters of their portfolios in high-rated AA securities.

Some investors, though, might be willing to take more risk for higher yields.

Going For More Yield

While investors are pouring into muni bonds at record-breaking levels, the instruments are safer due to federal stimulus, says Wells Fargo Investment Strategy Analyst Michael Taylor. Illinois got its first credit upgrade in 20 years, along with other states. “We maintain a favorable view on municipal bonds,” Taylor said.

One option for higher yields is the VanEck High Yield Muni ETF (HYD), Rosenbluth says. It’s yielding 3.64% over the past 12 months. That’s equal to a 4.79% yield for a person in the 24% tax bracket. Another high yield option is SPDR Nuveen Bloomberg Barclays High Yield Municipal Bond ETF (HYMB). It’s yielding 3.31%, or 4.35% on a tax-adjusted basis.

Keep in mind, though, these two ETFs only put about 30% of their holdings in high-rated, investment-grade debt. So it’s wise to use these high-yield options “in tandem” with safer options in a portfolio, Rosenbluth says.

Know What You’re Giving Up For A Tax Break, Though

Muni bonds are a great tax break, especially if you’re in a high tax bracket or think tax rates will rise. But there’s a cost: Capital appreciation.

The prices of the top 20 largest muni bond ETFs are down an average of 0.5% this year going into Wednesday. During that period, the S&P 500 is up more than 16%. Additionally, the S&P 500 yields 1.31%, and some members pay much more. What’s more, investors might find places to park cash other than munis. More than $101 billion, for instance, flowed into stable coin cryptocurrencies this year, though more went into muni bond ETFs and mutual funds, says Nicolas Colas of DataTrek Research.

For now, muni bond ETFs are a popular place to find yield and dodge tax hikes.

Tax Break Darlings: Largest Muni Bond ETFs

By assets

ETF Symbol Assets ($ billions) Yield (12-month) Tax equiv. yield (24% bracket) YTD price % ch. Expense ratio
iShares National Muni Bond (MUB) $23.6 1.88% 2.48% -1.1% 0.07%
Vanguard Tax-Exempt Bond (VTEB) 14.2 1.73 2.28 -0.9% 0.06%
iShares Short-Term National Muni Bond (SUB) 6.2 0.83 1.10 -0.5% 0.07%
SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond (SHM) 5.0 0.94 1.24 -0.9% 0.20%
SPDR Nuveen Bloomberg Barclays Municipal Bond (TFI) 3.9 1.93 2.54 -2.0% 0.23%
VanEck High Yield Muni (HYD) 3.7 3.64 4.79 0.8% 0.35%
Invesco National AMT-Free Municipal Bond (PZA) 2.5 2.38 3.13 -0.9% 0.28%
First Trust Managed Municipal (FMB) 2.4 2.02 2.66 -0.1% 0.50%
JPMorgan Ultra-Short Municipal Income (JMST) 2.2 0.32 0.42 0.0% 0.18%
VanEck Intermediate Muni (ITM) 1.9 1.92 2.52 -1.9% 0.24%
Sources: IBD, S&P Global Market Intelligence, Morningstar Direct
Follow Matt Krantz on Twitter @mattkrantz


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