Funds specializing in municipal bonds, or munis, have performed well historically in comparison to other fixed-income securities such as Treasury bills. When evaluating bond funds, investors should look at several factors to decide what best fits their portfolio and investment philosophy. The best tax-free municipal bond funds should offer reasonable management fees and expenses that are comparable to similar products.
Obligation and Revenue
Some bond investors consider general obligation (GO) munis to be safer than revenue bonds because GOs are backed by the full taxing power and creditworthiness of the government entity issuing them. Revenue bonds, on the other hand, depend on the success of special projects. For example, a municipality might issue bonds to finance an upgrade in the local waterworks with the expense being passed to consumers through monthly utility bills. The increase in revenue could then be earmarked to pay off the bonds.
Ratings and Rankings
Investment research firm Morningstar Inc.'s ratings are a standard in the industry that investors look to for guidance when analyzing bonds. Funds are evaluated for overall return and risk based on past performance. The effect of fees and expenses on returns is also considered before ratings are assigned. Thus, one factor investors consider when choosing among the best funds are ratings for the fund as a whole and ratings for the individual bonds within the fund.
Risk and Reward
While rankings can add clarity to the task of judging the best funds, it is possible that a lower-ranked fund may be one of the best available when it comes to returns. High-yield bond funds tend to invest in riskier bonds. Because of this tendency, a higher reward is offered as an incentive to get investors to accept increased risk. In addition, bond funds investing in longer-term securities carry higher levels of interest rate risk. The best tax-free municipal bonds will therefore provide an equitable return for the risk involved.
In addition, the best tax-free municipal bonds are not always the oldest. However, to avoid funds that earn high returns initially and then fail, investors can look at historical returns. Those that have been around long enough to provide a substantial track record, such as 3-, 5-, and 10-year returns, give investors an idea of the stability level when measuring performance over time with a benchmark such as U.S. Treasury bills.
If avoiding state income taxes is a goal, single-state municipal bond funds may be a viable option. Some states do not require residents to pay income taxes on bonds issued within the taxpayer's state of residence. Keep in mind that the local political climate, state legislation and the financial strength of the issuer can all affect how single-state municipal bond funds perform.