In our ongoing efforts to create the most tax-efficient portfolio possible for our customers, we have added a new asset class, represented by a tax-exempt national municipal bond fund, the S&P National AMT-Free Muni Bond ETF (MUB), for primary domestic bond exposure. It will replace the US High-Quality bond index fund (AGG) in taxable portfolios.

Dividends paid on this ETF are exempt from federal taxes. We will continue to use AGG, the core bond fund, in IRA accounts, where tax-free dividends do not provide the same advantage.

Improved after-tax returns with municipal bonds

Municipal bonds are expected to increase after-tax returns by more than 1.0% per year, as compared to the asset class they replace. Below, you can see the pre-tax yields of the two asset classes side-by-side. MUB is currently yielding significantly more than AGG even before taxes, but that could change. What won’t change is the advantage built into MUB once you factor in federal taxes. At the highest possible federal rates (single, income of $400k+), nearly half of AGG’s dividend is lost to taxes, while MUB’s yield is unchanged. Even assuming a more common tax bracket (earning roughly $100-200k), the advantage is clear.

Ticker Pre-tax yield After-tax yield (43.4%) After-tax yield (28%)
MUB 2.90% 2.90% 2.90%
AGG 2.20% 1.25% 1.58%

The only drawback for investors is that munis are often thought to carry greater default risk than US Federal government debt. The US has yet to default in modern history, and has the ability to literally print money, which state and local governments do not.

So while municipal defaults are not unheard of, they are actually quite rare as compared to corporate bonds, and relatively benign when they occur. This is because municipal bonds are often either insured privately, or have the backing of the state in the case of a default. It’s also worth noting that when a municipal bond defaults, it tends to mean you get $0.80 back, rather than $1—rather than lose all your principal. Most importantly, MUB comprises more than 2,000 muni bonds across 44 states—diversifying away any default risk for a particular issuer.

Due to these factors, municipal bonds tend to have relatively high credit ratings—comparable in quality and long-term performance to the US High-Quality Bond index.

A look inside the new portfolio

What do you need to do?

Nothing. Existing customers’ portfolios will automatically be transitioned to the new asset class over the coming months. We will replace AGG with MUB and reduce the weight of LQD and BNDX; we will also then increase the weight of MUB in the portfolio in order to maximize its tax-exemption benefit. Customers using our new Tax Loss Harvesting+ service will have MUB as the primary ticker for the asset class, and Barclay’s Municipal Managed Money (TFI) as the alternate.

This post was updated on Aug. 5, 2014.