Gimme (Tax) Shelter: Protecting Your Income Using Municipal Bond Funds

Transcription

1 Mutual Funds Gimme (Tax) Shelter: Protecting Your Income Using Municipal Bond Funds By John Markese It happens every year. You exempt from federal taxes. Long-term gains on bonds held by the fund for more than one year or long-term gains on municipal bond fund shares held by an investor for more than a year are taxed at the federal level at longterm capital gains rates. State-specific municipal bond can t avoid it. And every year you vow to make some changes: Taxes. Why not use every legitimate tool to reduce them, particularly if it is comparatively easy to do so? If you are in a higher federal income tax bracket 25% or more and your portfolio currently generates income from bonds, CDs or other fixed-income investments that are not in tax-deferred accounts, then you should contemplate switching to a federal tax-exempt income source. And the easiest source of federal tax-exempt income is a municipal bond fund. The box on the next page shows you how to calculate the benefit you d receive from making the switch. Returns: More Than Income Mutual fund returns are total returns, however, as shown in Table 1 on page 6 and include both interest income and capital gains (losses), if any. Capital gains that are short term whether on bonds held by the fund or mutual fund shares held by the investor are taxed at ordinary income tax rates and are not 4 funds also offer the potential for an additional exemption from state and local taxes a particularly important exemption in a high tax state such as New York. [See AAII s annual Guide to the Top Mutual Funds for a listing of state-specific municipal bond funds (sent to all members in March).] The municipal bond funds in Table 1 are all national municipal bond funds and hold bonds from across the nation. The income received on bonds issued from your state that are in these national municipal bond funds, however, may qualify for exemption from your state or local income taxes. Check with each bond fund or family to determine your potential income exemption at your state and local level. But a warning: State and local tax laws are arcane (as if you didn t know it already). The national municipal bond funds reported on by the MutualFunds(4).p65 4 5/20/2004, 6:19 PM

2 Guide to the Top Mutual Funds are grouped by maturity in the table. Maturity Matters Look over to the average maturity column: This is weighted by the value of the portfolio bond holdings at each maturity, and you can see that while the general categories and the fund names provide some guide to maturity, the variations within a category and fund name can be wide. Is maturity that important? Yes. A quick glance down the fiveyear average annual total return column and your general conclusion is probably that longer maturities produce, on average, higher returns. The same is generally true for yields, a measure of your federal tax-exempt income. But there is a price to be paid for higher returns, and that is volatility. Study the 1999 and 2000 returns for a moment. When interest rates rise as they did in 1999 the prices of existing bonds fall and total returns decline, perhaps going negative as capital losses swamp interest income. The longer the ma- Tossing the Tax Burden: Tax-Equivalent Yields A simple way to illustrate the attraction of income exempt from federal taxes is to plug your marginal federal tax rate into the equation below. Taxable-equivalent yield = Where, TE yield = tax-exempt yield 1.00 marginal federal tax rate For example, if a municipal bond fund yields 4% and your marginal federal income tax bracket is 35%, then your taxable equivalent yield is 6.1%. 6.1% = interest income market value of investment 4.0% Getting a 4.0% yield that is federally tax-exempt is the same as earning 6.1% interest on a fully taxable investment. As the table below shows, the higher the yield and the higher the federal tax bracket, the more the benefit from the tax shield provided by an investment that generates income exempt from federal income taxes. If your marginal federal income tax rate is: Tax-Exempt Yield 10% 15% 25% 28% 33% 35% The taxable equivalent yield (%) is: 1 % % % % % % Duration: A Quick Loss/Gain Calculator Duration is particularly useful because it allows you to get a quick read on what will happen to your mutual fund when interest rates change. Roughly, if you multiply the actual or expected change in market interest rates by the duration of the bond mutual fund portfolio, you will derive the change in the value of the bonds within the portfolio, capital gain or loss: Interest Rate Change Duration = Change in Bond Value Here s an example. Assume you expect market interest rates to rise from 4% to 5% due to Federal Reserve actions, inflation fears or changes in the economy. If you are invested in the Fidelity Spartan Intermediate Municipal Income fund, with its 5.5 duration, then the capital loss potential would be 5.5%: (+)1.0% 5.5 = 5.5% Remember that bond values move inversely to the direction of interest rates, so the 1% increase causes a 5.5% loss. If market rates declined from 4% to 3%, there would be a capital gain of 5.5%: ( ) = 5.5% While this is not a mathematically precise use of duration, it is a useful rule of thumb and precise enough for you to understand one of the perils of mutual fund bond portfolios. June

3 Mutual Funds Table 1. National Municipal Bond Funds Exp. Fund Name (Ticker) Total Return (%) YTD* Yr Yield (%) Ratio (%) Short-Term Strong Short-Term Muni Bond Invt (STSMX) USAA Tax-Exempt Short-Term (USSTX) Vanguard Ltd-Term Tax-Exempt (VMLTX) Vanguard Short-Term Tax-Exempt (VWSTX) Intermediate-Term USAA Tax-Exempt Intermediate-Term (USATX) Fidelity Spartan Interm Muni Income (FLTMX) Northern Intermediate Tax-Exempt (NOITX) Vanguard Interm-Term Tax-Exempt (VWITX) T Rowe Price Summit Municipal Interm (PRSMX) T Rowe Price Tax-Free Interm Bond (PTIBX) Schwab Short/Intermed Tax-Free Bond (SWITX) Fidelity Spartan Short-Interm Muni Inc (FSTFX) Long-Term USAA Tax-Exempt Long-Term (USTEX) SAFECO Municipal Bond Investment (SFCOX) Vanguard Ins Long-Term Tax-Ex Invt (VILPX) Fidelity Spartan Municipal Income (FHIGX) Northern Tax-Exempt (NOTEX) Vanguard Long-Term Tax-Exempt (VWLTX) T Rowe Price Tax-Free Income (PRTAX) Dreyfus Municipal Bond (DRTAX) *As of April 30, Sources: AAII s Guide to the Top Mutual Funds and Quarterly Low-Load Mutual Fund Update, and fund prospectuses. Definitions of Risk Terms Average Credit Quality: An average of each bond s credit rating, weighted by the relative size in the portfolio. AAA is the high below falls into the junk category. Lower ratings increase yields to offset greater bondholder risks. Average Duration: A measure of a fund s interest rate sensitivity the higher the duration of a bond fund, the higher the duration, while longer maturities and lower coupon rates make duration greater. Average Maturity (Yrs): A weighted average of all the effective maturities of the bonds in a portfolio. The longer the matur when interest rates change. turity of the bond fund, the greater the impact. When rates fall or there is a rush to bonds from stocks, as happened in 2000 the reverse happens: Total returns rise as capital gains are added to interest income. Risk Measures The total risk index compares the individual fund to all funds, bond or stock; the index average is As you can see, these bond funds relative to all mutual funds have low risk, but the risk does increase, on average, as maturity lengthens. This risk is also evident when viewed through the category risk index, in which individual funds are compared with other funds in the same category. The average risk index for a fund in a category is A 1.25 category risk index implies that the fund s returns are 25% more volatile than the category average. In this table, the categories for the category risk index are short, intermediate and long-term national municipal bond funds. For example, Vanguard Limited-Term Tax-Exempt has a category risk index of 1.53, substantially more than the category; this is consistent with its average maturity of 2.9 years, which is the longest maturity of that category. However, the relationship between the category risk index and maturity is not perfect because other differences in the bonds held in a portfolio can 6

4 Average Risk Index Cat. Total Duration Maturity (Yrs) Credit Quality A AA AA AA AA AA AA AAA AA AA AA AA AA AA AAA AA AA AAA AA AA est investment grade and BAA is the lowest; anything risk. High coupon rates and shorter maturities lessen ity of the bond fund, the greater the impact on return affect volatility, including differences in coupon rates (the stated interest rate paid on the bond annually), call features or the presence of variable coupon rate issues. Duration is a mathematical risk measure essentially a measure of sensitivity to interest rate changes that captures all these portfolio and individual bond characteristics. Simply stated: The higher the duration of a bond fund, the higher the risk. High coupon rates and shorter maturities lessen duration, while longer maturities and lower coupon rates make duration greater. The box on page 5 provides an easy Where to Find Information on Municipal Bond Funds Performance and Risk Statistics AAII s Quarterly Low-Load Mutual Fund Update $24/year for AAII members; $30/year for non-members ; Returns for the recent quarters and year, plus compound annual returns for three years and five years. Total risk and category risk figures are based on monthly standard deviation figures for the last three years. Also provides yield data. AAII s annual Guide to the Top Mutual Funds Free to AAII members; $24.95 for non-members ; Yearly returns for the past 10 years; total and category risk, yield, and average maturity. Return, Maturity, Duration, and Credit Quality On-Line The following Web sites report performance data as well as standard deviation, average maturity, duration and credit quality. Type the fund s ticker symbol in the quotes box and look for portfolio information to view risk statistics. Morningstar.com Quicken.com SmartMoney.com Individual Bond Fund Check the fund s Web site for average maturity, duration and credit quality range. If duration and maturity are not available on-line, call the fund. Credit quality is spelled out in the investment strategies section of the fund prospectus. Taxation of Municipal Bond Funds Federal Tax Information: Internal Revenue Service State Tax Information: Federation of Tax Administrators (FTA) Sister States Tax Directory June

5 Mutual Funds rule for using duration when analyzing a bond fund. Finally, in terms of risk, the portfolio average credit quality is worth a look. Lower-credit-quality bonds can impact a portfolio if a state or municipality s economic situation deteriorates, requiring more debt to be issued or imperiling the interest payments on current outstanding debt. The average credit quality is listed for these municipal bond funds, with AAA the highest and BAA the lowest investment grade; anything below falls into the junk category. Lower average credit quality A rather than AAA, for example increases yields because bond issuers with lower ratings are less financially secure and are forced to pay higher interest to offset greater bondholder risks. The Strong Short-Term Municipal Bond Investment fund carries the lowest quality average and has the highest yield in its category, but a relatively low duration, because high yields on lowercredit-quality bonds push duration down. The Right Choice Are municipal bond funds the right choice for you? Ask yourself these questions: Are you in a relatively high federal income bracket, or do you reside in a high income tax state or municipality? Do you have interest income from investments that are not in tax-sheltered accounts, such as 401(k)s and IRAs? Do you want interest income exempt from federal and perhaps state and local income taxes? If you nodded your head yes, these funds might be worth your time to consider. John Markese is president of AAII. Brush Up on the Essentials With the Investor Library Investing Basics and Beyond.. $12 Teaches the beginning investor how to get started in investing by taking you stepby-step through the process of developing a personal investment profile while taking into consideration lifestyle and age. Learn how to develop a portfolio that reflects your investment profile. Stock Investing Strategies.. $16 Teaches you the basics of fundamental stock analysis. Using a simple worksheet, judge how fairly the market is pricing a stock of interest. Also, learn how to develop a short list of stocks to investigate using a computerized database. Portfolio Building... $12 Explains how to apply the essential concepts of portfolio building to real-world situations, from selecting the elements of your portfolio to managing it, and how major changes in your life can affect the mix of your portfolio. Retirement Planning... $12 Find out how much of your salary you need to save for retirement and the best way to reach that goal. Learn how to take maximum advantage of your company s 401(k) plan and determine if an IRA fits into your personal financial plan. Stock Market Winners... $16 Gain insight into the stock-selection strategies that have made pros such as Warren Buffett, Peter Lynch, and William O Neil investment winners. Learn the investment philosophy, methods for valuing stocks, and rules for portfolio building and monitoring of dozens of investment gurus. Find out how to develop your own stock screens based on their techniques. Special Offer Order All Five for Just $54 If you want to increase your investment success, these are the books to own. AAII s special Investor Library Combination Package is just $54 for AAII members a savings of 20%. Orders can be taken by phone at or