As interest rates inch higher, bond prices will be coming down. Bond values are at less risk when they are of a short or lower duration. If your concern is to park your money for the short term without loss in value, there are lower-duration bonds and bond funds available. Short duration municipal bond funds have the dual advantage of the low risk of bond values dropping as well as being tax exempt.
Tax Free & Higher Returns
Low duration municipal bond funds have the potential to provide returns higher than what a money market or savings account could provide. There is also the added benefit of the income being tax free. Municipal bond funds can contain a mix of municipal bonds of various states. However funds with municipal bonds of a particular state are also available. In addition to federal taxes, many municipal bonds also offer exemption from state and city taxes which can be very attractive to residents of cities like New York.
For such investors, state specific municipal bond funds would be most suitable.
Investment grade Munis
You should check to see that the short term municipal bond fund you are investing in, contains mostly investment grade municipal bonds. Moodys, Standard & Poor’s and Fitch ratings classify bonds. Investment grade municipal bonds are given a BBB or better rating by Moodys and a BAA or better rating by Standard & Poor’s and Fitch. Municipal bonds used to be considered very safe investments – however given the recent problems with Detroit, Puerto Rico and most recently the city of Miami which has been accused by the SEC of misrepresenting its financial condition, it is best to ensure that the fund contains investment grade securities since the purpose of investing in short term bond funds is primarily to protect your capital.
Not FDIC Insured
Municipal bonds are also not federally insured.
Tax Exemption may be Capped
On a further precautionary note, there is a proposal to overhaul the US tax code whereby the federal tax exemption will be capped at 28% of the municipal bond interest. Any interest over the 28% cap would be subject to taxes. This proposal would primarily affect those in the top tax bracket of 39.5%
Some tax exempt short term bond funds are the Tax-Free Short Intermediate Fund from T. Rowe Price, the Vanguard Short-Term Tax-Exempt Fund and funds offered by the USAA
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