Debt mutual funds invest in a wide range of debt securities. A fund may be classified depending on the primary type of debt instrument in its portfolio. Based on the type of debt security in focus, you can choose from different types of debt funds. One such option is a municipal bond fund. In this article, we will explore the meaning of a municipal bond fund, its taxation, its advantages and risks and more.
What is a municipal bond fund?
A municipal bond fund is a type of mutual fund that predominantly invests in bonds issued by local municipalities. These are local governmental bodies that oversee the administration, management and requirements of urban areas in the country. To raise funds for the purpose of financing urban development and infrastructural projects, these bodies may issue debt instruments known as municipal bonds. A municipal bond fund invests the collective capital from a group of investors in these debt instruments.
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Example of municipal bond fund
Let us discuss a generic example of municipal bond funds. Say a local municipal body has issued a new tranche of bonds to finance an urban development project. A mutual fund house or asset management company (AMC) may launch a new fund that invests primarily in such municipal bonds.
For the average investor, purchasing these bonds directly, managing the investment and deciding when to sell may be a challenge. So, they may choose to invest in a municipal bond fund that, in turn, invests in these debt instruments. By investing in mutual funds that are bond-focused, these investors can enjoy the advantage of professional fund management.
How does a municipal bond fund work?
A municipal bond fund invests the collective capital from a group of investors in debt instruments issued by local government bodies. This type of fund typically purchases a mix of investment-grade municipal bonds, a few other debt instruments and maybe some stocks and money market securities.
The fund is divided into units based on the total capital invested in the scheme. Investors then purchase units based on their proportionate capital contribution. Each unit of the mutual fund scheme has a net asset value (NAV) that increases or decreases based on changes in the value of the underlying bonds.
Municipal bond funds primarily focus on bonds that have high credit quality and low levels of risk. This makes them suitable for conservative investors and moderate risk-takers. That said, aggressive investors may also benefit from municipal bond funds if they wish to reduce the overall risk of their portfolios.
Advantages of investing in municipal bond funds
Investing in municipal bond funds can give you the following advantages:
- Diversification: By investing in a municipal bond fund, you can diversify your portfolio to include a different asset class.
- Professional investment management: Municipal bond funds are actively managed by professional fund managers that oversee fund administration and asset redemption.
- Reliable income: Municipal bond funds also give you the benefit of consistent income from the bonds in the asset mix.
- Lower risk: These mutual funds carry lower market-linked risk than equity-oriented investments, making them suitable for conservative investors.
- Accessibility: These funds also allow you to gain exposure to the municipal bond market with a relatively small investment via SIPs.
Types of municipal bonds in India
Depending on the purpose of issue, municipal bonds in India can be classified as follows:
Revenue bonds
These municipal bonds are issued to fund revenue-generating projects like laying roads, constructing buildings and other infrastructural activities. Investors benefit from the revenue generated by these projects.
General obligation bonds
These are municipal bonds that are issued to fund general administration and upgradation of infrastructure within an urban locality. They are backed by how creditworthy the issuing municipal body is.
Taxation of municipal bond fund
Municipal bonds are generally tax-free. So, any income earned from these securities is tax-free in the hands of the investor. If you are already in a high tax bracket and want to invest in some tax-saving instruments, municipal bonds may be suitable for your portfolio. However, if managing the investment directly may be challenging for you either because you are a beginner or because it is time-consuming, you can choose to invest in municipal bond funds instead.
Also read: How to calculate capital gains tax on mutual funds
Decoding the yield in municipal bond funds
If you are planning to invest in municipal bond funds, you can evaluate your options using the bond fund yield. This metric essentially compares the yield (or the payouts) from the fund with the investment’s value or price. Depending on the data considered, municipal bond fund yield may be one of two types, as outlined below:
- Trailing yield: This metric measures the payouts from the fund as a percentage of the mutual fund’s historical price. Typically, the price over the previous 12 months is considered for this purpose.
- Forward yield: The forward yield is based on the most recent payouts and distributions. To find this yield, you need to compare the most recent payouts with the current price. This will show you the forward yield.
Underwriting: A crucial process in municipal bond funds
The choice or popularity of a municipal bond fund depends primarily on the credit worthiness of the bonds in the fund’s portfolio. Here is where underwriting becomes crucial. It is the process of identifying and evaluating the creditworthiness of the municipal body issuing the bonds. Underwriters assess the risks involved in these bonds and compare them with the potential returns from the debt instruments. This directly affects the risk-reward profile of the municipal bond fund that invests in such bonds.
Downsides of investing in municipal bond funds
If you are planning to invest in a municipal bond fund, you should also be aware of the following limitations and risks:
- Interest-rate risk: Changes in the interest rates can directly affect the value of municipal bonds and consequently, the NAV of municipal bond funds.
- Credit risk: These mutual funds also carry the risk of default if the issuer is not adequately creditworthy. However, municipal bond funds broadly carry much lower credit risk than corporate bond funds.
- Liquidity risk: Some municipal bond funds may have large bid-ask spreads, which may adversely affect their liquidity and make it harder to redeem your investments. Read more about, liquidity risk.
How to invest in municipal bonds?
You can invest in municipal bonds in one of two ways, as outlined below:
- Direct investments: You can directly invest in municipal bonds as and when they are issued by the local government body. This can give you tax-free income. However, if you are a beginner to investments or if you lack the time and expertise required, this may not be the best option.
- Via municipal bond funds: To enjoy the advantage of professional fund management and to counter any lack of experience, you can consider investing in municipal bond funds instead. This will help you gain exposure to the municipal bond market even if you can only invest as low as Rs. 1,000 a month via SIPs.
Key takeaways
- Municipal bond funds are mutual funds that invest mainly in bonds issued by municipal bodies.
- These bonds are issued for the purpose of financing urban development projects.
- Investors with a low tolerance for risk can consider investing in municipal bond funds to preserve capital and earn income or profits, depending on how the bonds perform.
Conclusion
Ultimately, municipal bond funds are suitable investment choices for anyone who wants to diversify into the debt market without worrying about the lack of expertise or the time required to manage such investments. You can invest in these debt funds as well as over 1,000 other mutual fund schemes on the Bajaj Finserv Mutual Funds Platform. Compare different mutual funds on the platform and make a lumpsum or a SIP investment in the fund that best aligns with your financial goals
