Are Municipal Bond ETFs Right for Your Portfolio?

Over the past 12 months, I’ve added a few municipal bond ETFs (exchange-traded funds) to my taxable investment portfolio. 

I’ve done this to diversify my dividend income and reduce taxes in non-retirement accounts. 

These investments are easy to buy, have low volatility and risk, and provide monthly dividend income. 

I use the monthly tax-exempt income to automatically reinvest back into other investments, including more ETFs and dividend stocks. More on this strategy below. 

Municipal bond ETFs provide a tax-advantaged way to diversify away from stocks and generate passive income. 

Historical returns from municipal bonds are lower than stocks by a lot. But the risks are far lower as well. 

Since Treasury bonds and high-yield savings rates are so low, municipal bond ETFs are an alternative to increase your portfolio yield without a tax burden. 

Below is a list of municipal bond ETFs (jump to the list) with some details about each. I’ve also added a section to help you determine if they’re a good fit for your portfolio and investment objectives. 

But before we go there, I’ll explain a bit more about municipal bonds. 

What are Municipal Bonds?

Municipal bonds, or “muni bonds” or “munis”, are debt securities issued by government entities such as counties, cities, and states.

Entities issue debt to fund operations, refinance old debts or pay for community infrastructure projects like roads, bridges, water projects, or any public use project that requires borrowed money to finance. 

Bond issuers pay the purchasers regular fixed interest payments. The principal is paid back in full at maturity. 

For investors, municipal bonds are tax-efficient because the dividend payments are not taxed at the federal level and state level, too (only if you buy bonds issued by your state of residency).

The favorable tax treatment makes them a convenient investment in non-retirement brokerage accounts and not as valuable for retirement accounts (IRAs). 

Generally, municipal bonds are low-risk investments because state and local governments have tax authority over their residents, so the debts are secured by the ability to collect tax revenue.

When governments over-extend themselves, governments can default on their debt. So these are not risk-free.

But usually, governments remain solvent and can refinance their way out of peril.

The key for investors is to diversify away from default risk.

Why Municipal Bond ETFs?

There are plenty of individual muni bonds out there. Governments borrow a shit ton.

Some online brokers make it easier to buy bonds than others. 

You should always buy multiple bonds to diversify if you purchase individual muni bonds. 

One popular strategy is to construct a bond ladder where the investor buys various bonds at differing maturity dates to create a stable income stream.

However, there’s an easier way to get the tax-advantaged income and diversify — municipal bond ETFs.

I first started researching these investments when my Dad asked me to help allocate some money in his taxable stock portfolio.

I saw an opportunity to decrease risk (he’s in his 70s), generate income, and avoid taxes.

ETFs are securities that trade on the NYSE and NASDAQ like stocks. So it’s easy to own them.

Even better, these funds own thousands of different municipal bonds.

Owning one ETF gives you exposure to a wide range of debt securities, diversifying your income stream across various state and local governments.

Large financial institutions such as Vanguard and Blackrock manage the funds, and they are regulated by the Securities and Exchange Commission (SEC), which adds a layer of consumer protection. 

Municipal Bond Fund Characteristics

Municipal bond funds come in different forms. Here are a few characteristics to consider. 

ETFs vs. Mutual Funds

I focus primarily on ETFs in this article because that’s how I’m investing. 

You can buy them through any online broker, including my favorite for beginner to intermediate buy and hold investors, M1 Finance (review).

But you can also own municipal bond mutual funds.

If you’re with Vanguard, Fidelity, or other big mutual fund providers, there are index mutual fund equivalents to the ETFs I highlight below.

You can also find managed mutual funds with higher yields (and fees). 

The downside with ETFs compared to mutual funds is there are far fewer municipal bond ETFs from which to choose. When you get into mutual funds, there are many more choices, including single-state funds.

Index vs. Managed ETFs (aka Passive vs. Active)

Many investors prefer index funds and ETFs to reduce management fees. 

Index funds aim to match the performance of an existing market index. 

Owning index funds exposes your portfolio to a broad array of investment securities. 

Managed funds have higher fees because a team of investment professionals work to increase the returns on these funds, picking individual bonds with higher yields and monitoring the increased risk.  

The main objective of managed funds is to outperform the target index, and they typically invest in fewer securities with higher risk to attempt to achieve the result.

Whether or not they outperform the index, after fees, is a risk the investor takes. 

The most significant municipal bond index is the Standard & Poor’s National AMT-Free Municipal Bond Index.

Maturity (Short-term, Intermediate, and Long-term)

Municipal bonds funds and ETFs have varying average bond maturities (time until the bond is fully paid back).

Generally, longer-term bonds have higher yields because the investor is taking more risk over time.

Shorter-term bonds have lower yields and risk because they are nearing maturity. 

Here’s the breakdown of short to long-term muni bonds maturities:

• Short-term: Less than one year to five years
• Intermediate-term: 5–10 years
• Long-term: 10 years or longer

All bond ETFs have a mix of maturities, but the average of all debts is what categorizes them in one of the three ranges above. 

Single-State Municipal Bond Funds

Municipal bond dividends are free from federal taxation. They can be tax-free in your state of residence too, if, you buy a state-specific fund. 

Single-state municipal bond funds are available from most sizable mutual fund providers, including Fidelity and Vanguard. These are typically mutual funds and not ETFs. 

For example, the Fidelity® California Municipal Income Fund (FCTFX) objective is to seek a high level of current income, exempt from federal and California personal income taxes.

So if you live in California and buy that fund, you won’t pay federal or state taxes on the dividend income. 

Non-single state ETFs diversify across U.S. municipalities. 

Credit Quality

Municipal bonds are rated (AAA, AA, A, BBB, BB, etc.) just like corporate bonds.

The higher the rating, the higher quality the bond (and lower yield). As quality decreases, risk and return increase. 

How are Municipal Bond ETF Dividends Taxed?

Municipal bond dividends are not taxed at the federal level, so you save money.

The income is still reported to tax authorities.

If you receive a dividend from a municipal bond ETF, it will show up on line 11 (Exempt Interest Dividend) of your 1099-DIV statement.

Then, the value will go on line 2a of your 1040 tax return as tax-exempt interest (as of TY2020).

If you own a municipal bond ETF in a retirement account, it won’t get taxed there either. But the main benefit of these investments is achieved in taxable accounts.

Capital gains distributions, if any, will be taxed. However, looking at some of the largest municipal bond ETFs, they seem to avoid capital gains distributions. 

Who Should Own Municipal Bond ETFs?

Retirees and those building their income before retirement tend to favor municipal bond ETFs more than young people. 

The investments may work well in your portfolio if you want to:

• Diversify away from stock dividend income in taxable brokerage accounts.
• Earn higher yields than government bonds, high-yield savings accounts, money markets, and CDs.
• Reduce your tax burden on income in non-retirement brokerage accounts.
• Lower portfolio risk and volatility.
• Hedge against market downturns.

Also, ETFs are for people who use brokerage accounts that offer limited access to low-fee mutual funds.

The big brokers such as Fidelity and Vanguard offer municipal bond funds with more variety and lower fees. If you have access to mutual funds and the fees are lower than ETFs, go with those.

Otherwise, investors that use smaller brokers with reduced mutual fund access can buy the ETFs with ease. 

Most younger investors (under age 40) are more likely to seek higher risk and return from buying growth and dividend stocks. 

For comparison, I’m 45-years old, and bonds make up less than 8% of my total invested assets. Municipal bonds are less than 2%. 

I’ll slowly increase my bond to stock ratio as I age but likely remain more biased toward stocks for the next 20+ years. I also own domestic and international bond mutual funds in retirement accounts. 

Municipal Bond ETF List

Here’s what stands out to me as important when it comes to selecting municipal bond ETFs. 

• Net Assets – I want to invest in the larger and more established ETFs, so there’s ample liquidity (lots of shares traded). 
• Low Fees – Lower fees let me keep more dividends. Index ETFs have lower fees than managed funds. 
• Number of Holdings – This is the primary indicator of diversification. The more holdings, the lower the default risk.
• Yield – The annual dividend expressed as a percentage of the amount invested. $1000 invested with a 3% yield would pay the investor $30 per year in dividends ($2.50 per month).
• Total Returns – Dividends plus capital appreciation of the investment. The prices on these investments don’t fluctuate a lot but do tend to rise when there’s market uncertainty. I use a 5-year annualized total return in the table below. 

Investing in municipal bonds is not risk-free, but they are considered a safe investment vehicle for capital preservation and income. They make a compelling alternative to cash when the best money market accounts pay just 0.50%. 

Below is a sample of municipal bond ETFs I’ve come across in my research. The table is sortable.

I typically don’t recommend individual securities. But if anyone is interested in this asset class, MUB and VTEB are both good options for further research.

Both are diversified index ETFs with low expenses and several thousand holdings. They are by far the most popular municipal bond ETFs out there. 

Google any of these and add ‘prospectus’, and you can see the direct bond holdings by state in each fund. 

How I’m Investing in Municipal Bond ETFs

I own municipal bond ETFs in my primary Fidelity brokerage account and my M1 Finance dividend reinvestment account. 

In M1 Finance, I created a monthly dividend pie which includes VTEB, HYMB, MUB, SHM, and a preferred stock ETF (PFF).

The monthly dividend pie is 1/5 of my total M1 Finance portfolio. The other four pies contain 20 dividend stocks (five in each). 

M1 Finance works differently than traditional online brokers. Investors design their ideal portfolio first, then fund it over time.

When I deposit new funds, or my cash balance reaches $25 from dividend income, the system automatically invests the cash into the most underrepresented holdings in my portfolio.

This way, I’m always reinvesting dividends into undervalued stocks and ETFs in my account.

It’s a compounding machine. 

As I write this, the monthly dividend pie has a net yield of about 2.4%, and it’s very low risk. Much of the yield is tax-free (except PFF).

When I started, I decided to pick just one fund, VTEB. However, as I researched these investments more, I realized that VTEB and MUB hold different bonds even though they are based on the same index.

So I bought both to round out my pie with five holdings like the other pies. Choosing either MUB or VTEB is sufficient.

Municipal Bond ETF Pros

• Federal tax-exempt income in taxable accounts
• Broad diversification
• Monthly income
• Non-correlated to stocks
• Conservative alternative to cash savings and Treasury bonds

Municipal Bond ETF Cons

• Low returns
• Only beneficial in taxable accounts (non-retirement)
• Not exempt from state taxes

Do you own any municipal bond ETFs? Which ones?

Photo via DepositPhotos used under license

Craig Stephens

Craig is a former IT professional who left his 19-year career to be a full-time finance writer. A DIY investor since 1995, he started Retire Before Dad in 2013 as a creative outlet to share his investment portfolios. Craig studied Finance at Michigan State University and lives in Northern Virginia with his wife and three children. Read more.