Bond funds have been a boon to the municipal bond market, especially the exchange-traded variety, attracting investors seeking an economical vehicle for tax-exempt income. But are they the best choice for everybody?
Just as an increasing number of wealthy people are opting for so-called concierge medical services, well-heeled investors often can do better with a specialist who assembles and manages a bespoke package of munis for them. To be sure, funds, especially ETFs that charge as little as 0.03% to manage a broad, diversified portfolio of muni bonds, are a reasonable overall choice.
But there are advantages for those with muni holdings of $250,000 or more to opting for an individualized, actively managed portfolio, says John Mousseau, chief investment officer of Cumberland Advisors, a Sarasota, Fla., asset manager for individuals and institutions. While that makes him not exactly disinterested in this question, there are unique aspects of the muni market he cites for his preference.
Unlike equities, for which Warren Buffett has famously said that the ideal holding period is forever, munis provide unique opportunities for active management. Notably, tax swaps -- exchanges of one bond whose price has declined for a similar issue -- can meaningfully add to returns, this muni veteran says. Booking tax losses on bonds can be an especially valuable offset to capital gains realized on stocks residing at record levels.
Vanguard founder Jack Bogle said about stock index funds that rather than searching for the needle in the haystack, just buy the whole haystack. But with bonds, and especially munis, the wheat can be separated from chaff. Bond indexes are made up of the largest issues, so index funds are constructed along those criteria -- regardless of the bonds' value.
That's especially true at the shorter end of the muni bond market, which makes up a sizable portion of bond indexes. Yields on bonds due in 10 years or less are significantly lower than their taxable counterparts, including those in the risk-free Treasury market, even on an after-tax basis.
For instance, a top-grade two-year muni yielded only 2.33% this past week. For an investor in the top federal tax bracket (37% plus the 3.8% net investment income tax, for a total of 40.8%), that is equivalent to a 3.94% taxable yield -- less than the 4.13% from the garden-variety two-year Treasury note. Even California residents facing a total 54.1% top federal and state bracket still would come out ahead after taxes with the Treasury given its exemption from state and local taxes.
But some tax-averse individuals are irrationally loath to render unto Uncle Sam or their state and instead accept a lower after-tax return on short-to-intermediate-term munis.
Longer maturities do provide a significant after-tax advantage, however. A 4.14% yield on a top-grade 30-year muni would be equivalent to nearly 7% on a similar Treasury, which yielded 4.96% this past week. For a Golden State resident in the top bracket, a 4.14% yield from a California credit would be equivalent to over 9% on a fully taxable corporate investment. Such a return is competitive with the long-run record of equities, especially at their current exalted valuations, Mousseau observed in an interview.
That in-state tax exemption became more valuable with the cap on the deductibility of state and local taxes from federal returns, he noted. And while the limit was increased to $40,000 last year from $10,000 beginning in 2018, for wealthy investors in high-tax states such as California and New York that deduction may cover only a fraction of state income and property taxes. That means a national muni ETF wouldn't provide the optimum after-tax return.
To be sure, there are single-state muni funds. Yet Mousseau points to other credit criteria he emphasizes in security selection. In particular, he prefers revenue bonds from entities that provide essential services. Traditionally, general obligation bonds, which are backed by taxes and a governmental unit's promise to pay, had been considered the strongest credits in the muni market. Notwithstanding these supposedly ironclad protections, reality intervened when these promises were pressed.
When Detroit filed for bankruptcy in 2013, Mousseau recalled, the sale of the city-owned art museum to pay bondholders was rejected by the judge overseeing the case. Rather than rely on such legal aspects of GO bonds, he prefers bonds from an entity such as the Port Authority of New York and New Jersey, the sprawling agency that operates the major airports in and around the Big Apple and the bridges and tunnels that connect the two states, among other functions. Its tolls and other revenues give the agency's bonds strong ratings of AA- by S&P and Fitch and an equivalent Aa3 from Moody's. Another sector Mousseau mostly avoids is the debt of colleges and universities, many of which face declining enrollments and, in some cases, bankruptcies.
An often-overlooked option is taxable municipal bonds, which provide yields competitive with corporate securities and typically higher credit quality. One example is bonds to fund water and sewer infrastructure for Lincoln Financial Field, home of the NFL's Philadelphia Eagles and one of the FIFA World Cup sites. Since the project benefits a private entity, the bonds didn't qualify for federal tax exemption.
While Mousseau sees long-term interest rates as having made a secular low in 2021, when the Treasury 10-year yield fell to a historic nadir of 0.5%, he's bullish on muni bonds for the intermediate term. With the eventual end of the Iran war, deflationary trends he saw previously -- stresses on private credit, job losses from artificial intelligence -- plus falling oil prices may eventually provide room for Federal Reserve rate cuts. The emphasis on price stability from new Fed chairman Kevin Warsh is ultimately bullish for bonds, he added.
Such a scenario would benefit long-term bonds, which is the muni sweet spot. Those who can pay the price of admission would benefit from going that route. And if that doesn't pan out, swapping to book tax losses can mitigate the pain. That's one advantage of tailor-made over off-the-rack.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
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(END) Dow Jones Newswires
July 02, 2026 10:40 ET (14:40 GMT)
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