A Tax-Free Way To Get Higher Yields

Nick Lanyi's picture

Tuesday, June 28, 2016 - 12:30pm

by Nick Lanyi

It's been nearly eight years since the financial crisis, yet interest rates remain at recession-like levels. That's good news for economic growth -- but it's a dismal situation for conservative investors relying on income, including millions of retirees who don't want to take big risks to achieve a decent yield.

The traditional safe havens -- savings accounts, money market funds, CDs -- offer yields that are laughably low. Money market mutual funds investing in government paper currently yield only around 0.33%. Your bank may offer 0.6% on a money market account, which invests in corporate debt but is FDIC-insured up to $250,000. Five-year CDs pay 1.2%, which is a paltry annual return for the privilege of locking up your money for half a decade. And recall that these rates were even lower before the Fed raised short-term rates by 25 basis points (0.25 percentage points) in December.

Now, it's true that part of the reason that yields are low is that inflation has been close to nonexistent for years; some important goods and services -- such as gasoline, natural gas and flat-screen TVs -- have declined in price. So low yields haven't been devastating in terms of purchasing power. But for folks living off their savings who want to preserve principal over the long term, the prospect of low yields over the long term is troubling.

The good news is that there's a higher-yielding alternative to "cash" investments like savings accounts and money market funds that carries only slightly more risk: municipal bonds. Muni bonds -- and the funds that invest in them -- also have the advantage of being partly or fully tax-free: you don't have to pay federal income taxes on the income, and if you buy bonds or funds that invest solely in your own state's municipal bonds, you can forego state and local taxes, too. (Check with your accountant to make sure.)

Because of the tax advantage, municipal bond funds are especially attractive for investors in the highest tax bracket (for 2016, single filers making $415,051 or more, or joint filers making $466,951 or more); the taxable-equivalent yield declines for taxpayers in lower brackets.

While it's possible to invest in individual municipal bonds, it's smart to use mutual funds for your muni investments. A well-run diversified fund invests in a wide range of bonds (T. Rowe Price Tax-Free Income Fund (MUTF: PRTAX), for example, currently owns 442 bonds) -- which minimizes the damage should a bond be downgraded or an issuer defaults (a rare occurrence with investment-grade muni bonds in any case). Professional management also allows for identification of undervalued bonds and continual reinvestment into higher-yielding bonds if interest rates rise.

Now, remember that muni bond funds do carry more risk to principal than money market funds or bank accounts. However, that risk is fairly small, especially if you approach these as "buy and hold" investments. For example, Vanguard Intermediate-Term Tax Exempt Fund's (MUTF: VWITX) worst calendar-year share-price performance this century was -4.6% in 2013; its best was +6.1% in 2009. Over time, the ups and downs tend to cancel out, leaving you with the better-than-money-market income.

Municipal Bonds Are Good Income Investments

Source: Bloomberg, Wall Street Journal. *For investors in the 39.6% tax bracket

Here are two top notch municipal-bond funds that invest in high-quality municipal bonds:

T. Rowe Price Tax-Free Income Fund has an SEC yield of 1.33%, which equates to a taxable-equivalent yield of 2.2% for those in the 39.6% bracket or 2.0% for those in the 35% bracket. The fund invests in a national portfolio of bonds, with about 35% rated AA or AAA and another 43% rated A. Veteran bond manager Konstantine "Dino" Mallas, who has been with T. Rowe Price for 30 years and run the fund since 2007, is a perennial top performer who has beaten his benchmark over the past five years.

Vanguard Intermediate-Term Tax Exempt Fund currently has a SEC yield of 1.33%, which equates to a taxable-equivalent yield of 2.2% for those in the 39.6% bracket or 2.0% for those in the 35% bracket. The fund owns a diversified portfolio of bonds from across the country and leans toward top-rated bonds; 75% in the fund's portfolio are rated AA or AAA. Fund manager James D'Arcy has been in fixed-income portfolio management for 17 years, first at Columbia and now at Vanguard. The fund's expense ratio is only 0.2%, one of the lowest in its peer group.

Risks To Consider: Rising interest rates could cause municipal bond funds to decline, though over time that capital loss could be offset as the fund invests assets in higher-yielding bonds.

Action To Take: Buy one of the funds above to boost income with minimal risk. Municipal bond yields are especially attractive for investors in the higher federal income-tax brackets.

Editor's Note: Our team has done something unusual. We've created a retirement portfolio with only dividend-paying securities. Have we taken income investing too far? Click here to decide for yourself

Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.