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By Dr. Jim Dahle, WCI Founder
Lots of municipal bond investors wonder whether they should use a state-specific bond fund. While I’m a big fan of municipal bond funds (as opposed to buying individual muni bonds)—due to their additional diversification, convenience, and liquidity—deciding whether you should use a state-specific or a general municipal bond fund can be a bit trickier. There are three factors to weigh:
- Tax savings
- Additional cost
- Loss of diversification
Here is an email that illustrates the problem well:
“I’m about to open a taxable account for the purpose of investing a small amount ($5,000 per year) in a municipal bond fund. I am not sure how to calculate which option spends less on combined taxes and fees:
- The Fidelity Maryland Municipal Bond Fund (SMDMX) or
- The Vanguard Intermediate-Term Tax Exempt Bond Fund (VWITX)
Can you show me?”
OK, let’s explore this question.
State Muni Bond Fund or National Muni Bond Fund?
I told the emailer that, in her case, it really doesn’t matter much. In the grand scheme of things, this decision is almost trivial. Seeing a single additional patient is going to make a much larger difference in her financial life than this decision. But the more I pondered it, the more I thought it would be illustrative to actually run the numbers here as a demonstration of how to make these decisions.
First, let’s learn a little bit more about these funds. Morningstar is always a good resource.
The Fidelity Maryland Municipal Bond Fund (SMDMX)
- Expense ratio: 0.55%
- Duration: 6.2 years
- Credit quality: 8% AAA, 38% AA, 33% A, 17% BBB
- Total bonds: 130
- Total assets $179 million
The Vanguard Intermediate-Term Tax Exempt Bond Fund (VWITX)
- Expense ratio: 0.17%
- Duration: 4.35 years
- Credit quality: 17% AAA, 48% AA, 25% A, 8% BBB
- Total bonds: 13,998
- Total assets $71.9 billion
As you can see, the Maryland-specific fund is more expensive, more risky, and dramatically smaller and less diversified. Doesn’t sound very good, does it? But what if you can save some additional taxes? Does that make up for all of the above? Let’s run some numbers and find out.
More information here:
What Bond Fund Should You Hold?
Taxable vs. Municipal vs. State-Specific Municipal
The best way to decide what type of bond to use in your taxable account (assuming you want to hold any bond in your taxable account) is to calculate the after-tax bond yield of the fund so you can compare apples to apples. This calculation, of course, assumes that all else (duration, credit quality, expense ratio, diversification, liquidity, etc.) is equal, which it never is. But let us, just for a moment, assume that it is.
Let’s compare the Vanguard Intermediate-Term Bond Index Fund (5.39% yield), the Vanguard Intermediate-Term Tax-Exempt Bond Fund (4.07% yield), and the Fidelity Maryland Municipal Bond Fund (3.87% yield) for a Maryland investor with a federal marginal tax rate of 35% and a Maryland marginal tax rate of 5.75%. Note that the marginal tax rate is what matters, not the effective tax rate.
The first thing you do is calculate the after-tax yields (these yields were current when I wrote this post in July 2022, so be sure to do the calculation for yourself using current yields because yields change over time.)
- Taxable 5.39% * (1-35%-5.75%) = 3.19%
- General Municipal Bond 4.07% * (1-5.75%) = 3.84%
- State-Specific Municipal Bond 3.87% * 1 = 3.87%
As you can see, the difference in the two municipal bond after-tax yields for this investor is trivial, and they really should not be used to make a decision. The other factors are far more important. The difference between 3.84% and 3.87% is only 0.03%. Multiply that by the $5,000 the investor will have in muni bonds this year, and that is only $1.50. I’m certainly not going to pick an investment that is less diversified, less liquid, and riskier for $1.50 a year.
Since this investor is in a pretty high tax bracket, why isn’t the difference higher? Part of that can be explained by the expense ratio. The Fidelity fund has a significantly higher pre-fee yield, but Fidelity is keeping an extra 0.55% – 0.17% = 0.38% that the Vanguard fund is not.
I probably wouldn’t sweat the significantly higher expense ratio all that much on a $5,000 investment either. That fund only costs $19 more per year than the cheaper Vanguard fund.
More information here:
The Fed Keeps Raising Interest Rates; Should You Start Buying Bond Funds Again?
How Much Yield Is Enough?
So, how much more after-tax yield would be enough for you to give up some diversification and liquidity (assuming similar levels of risk)? I think at least 0.25%-0.5% after-tax would be enough for me, but others might require more or less yield to compensate them. We’re obviously not getting anywhere near that in this case.
The Bottom Line
There is at least one Utah-specific muni bond fund. UTAHX has an expense ratio of 0.87% and charges a load of 3%. It only has 299 bonds in it and has a yield of 2.35%. Needless to say, I don’t use it. I use the Vanguard Intermediate-Term Bond Index Fund due to its lower costs, better management, superior diversification, improved liquidity, and higher after-tax yield. I find most state bond funds have similar issues. Vanguard does offer a few well-run, state-specific bond funds (California, Massachusetts, New Jersey, New York, Ohio, and Pennsylvania) that are probably worth checking out for residents of those states. But for the rest of us, you should probably just stick with a general municipal bond fund.
What do you think? Do you use a state-specific muni bond fund or a general muni bond fund? Why? Comment below!
