Insured tax-free income funds are mutual funds that collectively invest contributions from individual investors into a single portfolio of bonds. Tax-free bonds are generally issued by municipalities or state governments and are promises of these entities to pay investors their principal back, along with interest.
Tax-free bonds are federally tax-free investments, and they are usually state tax-exempt to investors who are residents of the state issuing the bonds. Advantages of insured tax-free funds include diversification, tax-exempt income and protection against default, while mutual fund fees, interest rate risk and reinvestment risk are negatives of these funds.
Diversification
By their very nature, all mutual funds offer you at least some level of diversification. In fact, one of the primary benefits of mutual funds as an investment class is the ability to instantly own multiple investments with a single purchase. In terms of tax-free bond funds, you are hiring a professional manager to research and buy hundreds if not thousands of bonds on your behalf. Even when buying insured bonds, the level of diversification offered by a multi-bond portfolio helps to limit your overall investment risk.
Tax-Free Income
By definition, a tax-free bond fund offers you income that is exempt from federal income tax, and possibly state tax as well. While stock dividends and taxable bonds may pay you a higher stated rate of interest, after deducting the effects of taxes, tax-free income can often offer you a higher overall rate of return.
Insured Bonds
When you buy an insured tax-free bond fund, while the fund itself is not insured from loss, the individual bonds generally are. While diversification provides you with a level of protection from the default of any individual bond, insurance all but negates this risk entirely. Thus, if you invest in an insured tax-free bond portfolio, you don't have to worry much about the economy worsening or individual municipalities getting into financial difficulty, as the insurance will pay the bond off in the event of default.
Interest Rate and Reinvestment Risk
All bonds suffer from interest rate risk and reinvestment risk, and insured tax-free bond funds are no different. Interest rate risk is the risk that interest rates will rise while you own your bond fund, as bonds go down in value when interest rates rise. On the other side of the coin, reinvestment risk is the risk that interest rates will fall, meaning that bonds that mature or are redeemed have to be reinvested at the new lower interest rates, thus decreasing your income. Bond funds are particularly susceptible to interest rate risk as there is no maturity date on a bond fun. Unlike individual bonds, which carry an issuer's promise to pay you back your principal at maturity, in bond funds, any maturing bonds are simply reinvested by the fund manager, rather than being paid out to you as income.
Fees
If you purchase an individual bond from your broker or a bond dealer, you will usually pay a small commission at the time of purchase. After that, you pay no fees for the entire time that you hold your bond. Mutual funds, on the other hand, often charge upfront sales charges of up to four or five percent, along with annual expenses of up to one-and-one-half percent or more. These fees can substantially decrease the overall net return on your mutual fund investment.
Member Comments