CA Muni Bond Funds
Per my investment policy, I want to invest 5% of my portfolio into municipal (muni) bond funds. They will give me better yield than CDs due to their tax-exemption status.
What is muni bond?
It is a bond issued by local governments (such as a state, municipality or country) or their agencies to finance projects like school, roads, hospitals, water treatment, or other infrastructure. (See more at Wikipedia)
Interest income from muni bonds are exempt from federal, state and local taxes in most cases, so muni bonds are very effective for investors in states with high income taxes and high federal income tax bracket.
Power of tax-exemption
For example, there is a software engineer in Los Angeles who earns $170,000 as adjusted gross income is in the 33.3% income tax bracket (federal 24% + CA state 9.3%).
If she puts $10,000 into 12-month CD with APY 2.75% in the taxable account, she will earn $275.00 as interest and pay $91.57 as taxes. So her net income is $183.43.
If she puts it into VCAIX (Vanguard CA intermediate-term tax-exempt fund) with average 2.60% distribution yield I assume, she will net $260.00 after a year. Her muni income will be equivalent to a CD with APY 3.90% after tax!
How to calculate equivalent after-tax yield
It is easy to calculate equivalent after-tax yield that is equivalent to tax-exempt yield.
equivalent after-tax yield = muni bond interest rate / (1 - marginal income tax rate)
Muni bond is not risk free
Although it is issued by local governments, it can go default. S&P Global Ratings said that in 2017 “the overall default rate of 0.09% resulted largely from 14 defaults in Puerto Rico, compared with just six in other parts of the U.S.”. We need to make sure the muni bond we’re investing have investment grade ratings (BBB or above).
Just like any bond investment, increasing interest rate could be a risk.
I used 33.3% tax rate to calculate the equivalent after-tax yield. Your marginal tax rate may be different.
TTM (trailing twelve month) yield of the past does not predict future yield. Interest rate changes over time.
Each fund have different strategies and different holdings. Comparison is not simple.
For example, iShare CMF seems more conservative than others. It invests most of its assets into A or higher rated bonds. It may explains its yield lower than others.
Muni bond funds are definitely better than any savings or CDs. However, None of the funds in above comparison would generate return higher than my 30-year mortgage at 3.99% APR. The highest TTM Yield is 3.31% of VCITX. So I will keep using most of my saving into paying down mortgage.