Many investors include municipal bonds and municipal bond funds in their portfolios as a way to help their own communities, their home states or their country build essential infrastructure and finance other far-reaching projects. Their investments are to be commended as examples of contributing in ways that “do good.”
The U.S. government and many states and local municipalities actively encourage these types of investments by exempting from taxation the net investment income that can be generated by municipal securities. These exemptions, which apply to all taxpayers who hold individual muni bonds or invest in municipal bond funds, mean that a muni investment will provide more after-tax income than a taxable income that has the identical nominal yield. Put another way, the yield on a taxable bond has to exceed the nominal yield on a tax-free bond for the taxable yield to put as much money in an investor’s wallet. (Read more about The Benefits of Tax-Free Investing.)
To compare a tax-free and taxable investment, investors must consider a muni investment’s taxable equivalent yield (TEY). The calculation is dependent on where the investor lives as well as the tax rate levied for the investor’s tax bracket. Our TEY tool can be used to compare yields and to help investors appreciate the difference that tax exemptions make on their municipal holdings.
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates, or an expectation of rising interest rates in the near future, will cause the values of a Fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at, or near, historic lows. When interest rates rise, bond prices fall and a fund’s share price can fall. Municipal bonds are subject to default on income and principal payments. Further, a portion of some funds’ distributions may be taxable and may increase alternative minimum tax (AMT) for investors subject to that tax; distributions from net realized capital gains are taxable as capital gains.
The funds invest in below-investment-grade debt securities, which may entail greater credit risks, as described in each fund’s prospectus. These securities (sometimes called “junk bonds”) may be subject to greater price fluctuations and risks of loss of income and principal than investment-grade municipal securities. The funds may invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. The funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions.