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What is a municipal bond?
A municipal bond is an IOU issued by state and local governments and their agencies to raise money to fund public projects such as schools, hospitals and bridges. The entity that issues a bond makes interest payments to bondholders to compensate them for the use of their money until the bond is repaid. These interest payments are generally exempt from federal income tax. In addition, for residents of the state in which the bond was issued, interest payments are also typically exempt from state tax.
What is a tax-free income fund?
A tax-free income fund is a mutual fund that invests primarily in municipal bonds. The portfolio manager actively buys and sells bonds in an effort to meet the fund’s stated investment goals. The funds offer investors income exempt from federal tax and, in many cases, state and local income tax.1
Types of tax-free income funds
Below are descriptions of several different types of tax-free income funds. The funds vary based on the types of bonds they invest in and the length of their average maturities.
National tax-free funds. These funds invest in municipal bonds issued by state and local governments anywhere in the country. Dividends are free from federal income tax.1, 2
State-specific tax-free funds. These funds invest in municipal bonds issued within a single state. As most states do not tax the income generated by their own bonds or those issued by their governmental entities, the income these funds distribute is generally exempt from federal tax and state tax for residents of that state.1
Insured tax-free funds. These funds invest in municipal bonds covered by insurance policies. In the event of default by a bond issuer, an insured municipal bond is guaranteed to make timely principal and interest payments. Insurance offers investors greater protection against bond defaults and helps to preserve a bond’s market value.1, 2
Please note, neither municipal bonds nor municipal bond fund shares are insured by any U.S. or other government agency. Insurance does not protect shareholders from market volatility, and fund shares will fluctuate in value.
High-yield tax-free funds. Typically, these funds invest in lower-rated municipal bonds, as rated by a credit rating agency such as Standard & Poor's or Moody's. Lower-rated bonds typically offer higher yields to compensate investors for higher risk.1, 2
It should be noted that high-yield municipal bonds generally have a greater risk of default due to their lower credit quality.
Short- and intermediate-term tax-free funds. As their names suggest, these funds are categorized according to the average maturity of the municipal bonds in which they invest. As a rule, the longer the average maturity of bonds in a bond fund, the greater the income and expected return, and the greater the potential share price volatility.1, 2
Tax-exempt money funds. By purchasing short-term municipal securities, these funds are managed to maintain a steady $1.00 per share net asset value.1, 2
An investment in a money fund is not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money fund.
Footnotes
1. For investors subject to the alternative minimum tax, fund dividends may be taxable. Distributions of capital gains are generally taxable. To avoid the imposition of 28% backup withholding on all fund distributions and redemption proceeds, U.S. investors must be properly certified on Form W-9 and non-U.S. investors on Form W-8BEN.
2. Dividends are generally subject to state and local taxes, if any.
What are the risks?
Municipal bonds are sensitive to interest rate movements, and a fund's yield and share price will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a fund adjust to a rise in interest rates, a fund's share price may decline.
In general, securities with longer maturities are more sensitive to interest rate changes. Funds with investments concentrated in a single state are subject to greater risks of adverse economic and regulatory changes in that state than a fund with broader geographical diversification. These and other risks are detailed in a fund's prospectus.
A financial advisor can add perspective
If you have questions about investing in tax-free income funds, we encourage you to contact your financial advisor, who is best suited to help you make investment decisions based on your individual investment goals and risk tolerance.
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