Municipal Bond Funds
Municipal Bond Funds
Municipal bonds are issued by state and local governments and are exempt from federal income tax (and often state and local taxes). Municipal bond funds offer tax-free income for higher-income investors.
Key takeaways
- Municipal (muni) bonds are issued by states, cities, and other local governments and are exempt from federal income tax.
- MUB (iShares National Muni Bond ETF) and VTEB (Vanguard Tax-Exempt Bond ETF) are diversified portfolios of investment-grade munis from all U.S. states.
- The tax-free yield must be high enough to justify the lower pre-tax yield compared to taxable bonds. This depends on your tax bracket.
- Munis are only valuable in taxable accounts; in tax-deferred accounts (401k, IRA), there is no tax advantage.
- Muni bonds carry credit risk (states and cities can default) and are less liquid than Treasury or corporate bonds.
How municipal bonds work
A city needs to fund a new water system costing $50 million. Rather than paying cash, the city issues 30-year bonds, promising to pay coupons annually and repay principal at maturity. These bonds are "revenue bonds" if they are backed by the revenue from the water system, or "general obligation bonds" if they are backed by the city's general taxing power.
The city promises to pay, say, 4.0% annually. But here's the key: the interest income is exempt from federal income taxes. So a bondholder in the 24% federal tax bracket receives 4.0% pre-tax income that is not taxed—equivalent to 5.26% taxable income (4.0% ÷ 0.76).
For comparison, a taxable bond yielding 5.3% provides the same after-tax income to someone in the 24% bracket: 5.3% × (1 - 0.24) = 4.0% after-tax.
Tax benefits and tax brackets
Municipal bonds make sense only for investors in high tax brackets. An investor in the 12% federal tax bracket should compare a 4% municipal yield to a 4.5% taxable yield. The after-tax income is identical (4% vs. 4.5% × 0.88 = 3.96%), so munis offer no advantage.
An investor in the 37% top federal tax bracket should compare a 4% municipal yield to a 6.3% taxable yield. The after-tax income from munis is 4%, versus 6.3% × 0.63 = 3.97% after-tax on taxable bonds. Munis are slightly better in this case.
The calculation depends on your marginal tax bracket. Here are the equivalent yields (what a taxable bond would need to offer to match a 4% muni yield):
- 12% bracket: 4.55% taxable needed
- 22% bracket: 5.13% taxable needed
- 24% bracket: 5.26% taxable needed
- 32% bracket: 5.88% taxable needed
- 35% bracket: 6.15% taxable needed
- 37% bracket: 6.35% taxable needed
For someone in the 24% bracket earning $200,000 to $500,000 per year, munis might make sense if the taxable-equivalent yield is attractive. For someone in the 22% bracket earning under $200,000, munis are typically not worth the illiquidity tradeoff.
MUB and VTEB: Core muni holdings
MUB (iShares National Muni Bond ETF) holds roughly 3,000 investment-grade municipal bonds from all U.S. states, with an expense ratio of 0.06%. As of early 2025, MUB yields approximately 3.7% tax-free, equivalent to about 5.2% in pre-tax income for someone in the 28% bracket.
VTEB (Vanguard Tax-Exempt Bond ETF) is Vanguard's competitor, also holding approximately 2,000-3,000 investment-grade munis with an expense ratio of 0.06%. VTEB's yield is similar to MUB's.
Both funds hold a diversified portfolio of general obligation bonds (backed by taxing power) and revenue bonds (backed by project revenue). The diversity protects against single-issuer credit risk. Even if a major city (say, Detroit) had faced default in 2013, the impact on MUB or VTEB would be a small portion of a percent loss.
Maturity in both funds is typically intermediate (5-10 years), offering moderate duration (roughly 4-6 years).
State and local tax (SALT) benefits
Beyond federal tax exemption, many muni bonds are also exempt from state and local income taxes. An investor living in New York who buys New York municipal bonds gets federal tax exemption plus New York state and local tax exemption. The combined federal + state + local tax rate in New York can exceed 50%, making the after-tax return dramatic.
However, federal law limits federal tax deductions for state and local taxes (SALT) to $10,000 per year. This doesn't directly affect munis (the income is exempt, not deducted), but it reduces the value of state income tax deductions, making in-state munis less compelling for some investors.
MUB and VTEB hold munis from all states, so they provide federal tax exemption but not state tax exemption (unless you live in the state issuing the bonds). For someone in California or New York, a state-specific muni fund (California munis for California residents) would offer both federal and state tax exemption.
Credit risk and defaults
Municipal bonds have historically had low default rates. Since 2000, muni default rates have averaged under 0.3% annually, far lower than corporate bond default rates. However, credit risk is real. Municipalities facing tax base erosion (industrial decline, population loss) or mismanagement can default.
The 2008 financial crisis affected muni credit quality; a few issuers defaulted. Detroit's bankruptcy in 2013 raised concerns about pensions and retiree obligations straining muni finances. More recently, some smaller issuers have faced stress from reduced tax revenue during the pandemic.
Despite these risks, investment-grade munis (rated BBB or higher) remain safer than investment-grade corporates. MUB and VTEB focus on the safest tier (generally A-rated and higher), minimizing default risk. The historical experience suggests a well-diversified muni fund poses minimal default risk.
Liquidity and trading
Municipal bonds trade in a decentralized, illiquid market. Bid-ask spreads on individual muni bonds can be 0.5-2%, meaning a buyer pays much more than a seller receives. This liquidity is a major weakness compared to Treasuries or corporates.
However, MUB and VTEB, as ETFs, trade on exchanges with tight spreads (typically $0.01-0.05 per share). The ETF structure allows retail investors to access munis without the massive spreads of buying individual bonds.
When to use munis
Municipal bonds are appropriate only for investors who:
- Are in a high federal tax bracket (32% or higher, earning $200,000+ per year).
- Have significant taxable investment income (not tax-deferred accounts).
- Can tolerate slightly illiquid holdings with wider spreads than Treasuries or corporates.
An investor in a 401k or IRA should never buy munis. The tax-exempt status is wasted in a tax-deferred account. You could instead own higher-yielding taxable bonds and benefit from the tax deferral.
For a high-income investor in a taxable brokerage account, munis might represent 10-20% of a bond allocation—perhaps $200,000 of a $1 million bond portfolio. The tax savings compound over time, justifying the illiquidity tradeoff.
Laddering and individual bonds
Some investors prefer to ladder individual municipal bonds (buying a variety of maturities, each maturing in consecutive years) rather than holding a diversified muni fund. The advantage is predictability: you know your principal back at maturity without worrying about muni market cycles.
However, this requires $100,000+ in capital to build a meaningful ladder, access to a broker offering muni bonds (some don't), and the discipline to reinvest matured proceeds. For most investors, MUB or VTEB is simpler.
The muni market in 2025
As of early 2025, muni yields (around 3.7% for MUB) are close to Treasury yields (around 4.1% for intermediate Treasuries). The tax-free equivalent yield for a 32% taxpayer is roughly 5.4%, well above Treasury yields. This makes munis attractive for high-income earners.
However, if Treasury yields fall (rates decline), muni yields typically fall as well, reducing the tax-exempt advantage. The inverse is also true: if rates rise, munis rise with them.
Munis are not return generators; they are tax-deferral vehicles. The total return (yield plus price appreciation) is typically similar to equivalent-duration Treasuries or taxable bonds after accounting for taxes. The value is in deferring taxes through the exemption.
Next
Municipal bonds serve a specific purpose: tax reduction for high earners. Many investors lack the income level to benefit from munis but still seek higher yield. International bonds offer another path: broader geographic diversification and sometimes higher yield. The next article explores international bond funds.