Willingly or unwillingly investors need to file their income tax returns with the Internal Revenue Service by the April 15 deadline. Almost 150 million Americans are expected to file federal income-tax returns this year (read: Most ETFs Are Tax Smart, Is Yours?).
Though filing taxes cannot be avoided, one can definitely opt for ways to minimize the tax burden. Some smart investors can use legal measures to make the hole in their pockets a little smaller. "Taxes are the biggest drag on returns," says Rande Spiegelman, vice-president of financial planning at Charles Schwab.
There are various tax-exempt investment schemes including municipal bonds and certain money market funds, which one can invest in to reduce their tax burden. Tax-free income is certainly favored by all classes of investors. Specifically, municipal bonds can be great investment options for people seeking tax-free income for many years.
Municipal Bond in Focus
Municipal bonds or in short “munis” are bonds issued by city, state and country governments to raise money for different community projects including highways, new schools, or hospitals. Munis are basically loans made to state and municipal governments. General obligation bonds and Revenue bonds are the two types of muni bonds (read: Three Municipal Bond ETFs for 2014).
Like other bonds, these also provide regular interest income. However, the interest payments on municipal bonds are treated differently for tax purposes. While interest on Treasury and corporate bonds are taxed as regular income plus the applicable state income tax rate, the interest income from munis is exempt from federal tax and may also avoid state taxes. If a bond is issued in an area where one resides, it is exempt from state and local taxes.
Admitted that munis are a great way of generating tax-free income, these also come with lower yields compared to taxable bonds. However, if we take into account after-tax returns, municipal bonds fetch better returns for investors in high tax brackets. Thus, the higher tax-free equivalent yield provided by munis is what attracts the investors most to it.
Apart from the tax advantage, improving credit conditions among states and local issuers are also a factor which makes munis appealing as an investment option. Moreover, the demand-supply imbalance in the munis market has also worked in favor for these bonds.
Below we have highlighted three municipal bonds which can be added to an investor’s portfolio to pocket in tax-free returns. Each of these products has a Zacks Rank #2 or “Buy” rating (see all Municipal Bond ETFs here).
Market Vectors-Long Municipal Index ETF (MLN)
The fund seeks to provide exposure to investment grade municipal bonds holding a basket of 143 bonds. The fund tracks the Barclays AMT-Free Long Continuous Municipal Index for this purpose.
The fund is a good option for investors seeking to invest in the long end of the curve as it holds long-duration bonds with a nominal maturity of 17 years or more. The fund has an effective duration of 13.30 years, 30-day SEC yield of 4.06% and a great 6.72% tax equivalent 30-day SEC yield for those in the highest income bracket.
The fund’s assets are spread across numerous states with New York munis taking the top spot, followed by California and Florida. As far as sectoral allocation of the bonds are concerned, Health Care Facilities bonds have more than one-fourth exposure in the product, with Transportation bonds having 13.1% exposure.
The fund charges 24 basis points as fees. Though unpopular with an asset base of $76 million, it has yielded the best returns in the municipal bond space in the year-to-date time frame. The fund has returned 8.5% to date.
PowerShares Insured National Municipal Bond Fund (PZA)
The product focuses on investment grade insured tax-exempt debt publicly issued by the U.S. state or territory including Puerto Rico, or its political subdivisions, in the U.S. domestic market, tracking the BofA Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index.
With 165 securities in its basket, the fund is heavily tilted toward long-term securities as the fund allocates around three-fourths of its assets in bonds having maturity of 20 years or more. This results in a higher effective duration of 8.27 years and an effective maturity of 22.58 years (read: Three Biggest Mistakes of ETF Investing).
The fund has a 30-day Sec yield of 3.66% and a yield to maturity of 4.61%. The fund manages an asset base of $598 million and has gained 5.57% since the start of the year.
Short-Term National AMT-Free Muni Bond ETF (SUB)
For investors willing to invest in short duration munis, SUB is a good option to do so. The fund tracks the S&P Short Term National AMT-Free Municipal Bond Index, giving investors exposure to short-term investment grade U.S. municipal bonds.
The fund has a weighted average maturity of 2.12 years and a low effective duration of 1.98 years. However, the lower durations mean lower yields as SUB has a 30-day SEC yield of 0.27% or a tax equivalent 30-day SEC yield of 0.47%.
SUB manages an asset base of $838 million holding 762 bonds. Munis bonds issued by California, New York and Massachusetts occupy the top three spots taking more than 40% of fund assets.
This article is not intended as tax advice, please consult your tax advisor before any tax-related purchase or sale of securities.
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